When the Federal Reserve starts to raise rates, will institutional money-market funds remain the darlings of corporate treasurers? Institutional money-market funds were the most popular kid on the block in 2001 because they provided a cushion against declining short-term rates. Taxable institutional funds' assets grew by about $354 billion last year, and money funds became the most popular investing tool for sweep accounts. But the funds' tendency to lag interest-rate changes will be a liability once the Fed starts tightening, currently expected at its June meeting. "Once the Fed moves, the money will flow out" of money funds, says Peter Crane, vice president of iMoneyNet Inc., a Westborough, Mass., company that tracks money-market funds. "Certainly $100 billion to $200 billion of [last year's inflows] is relatively hot money." In fact, Crane says he expects 2002 to be the first year of negative asset growth for institutional money funds since 1983.That may turn out to be true, but the attraction of money-market funds isn't solely their yields, observers say. In an environment where credit quality is a big issue, the funds and their credit analysts offer an extra line of protection for corporate treasuries that don't have the resources to do their own credit analysis. That dependence is likely to moderate outflows, experts note. Compared with past tightening cycles, "there's going to be a much higher value placed on credit," this time around, says Denis McGonigle, an executive vice president of SEI Investments, an Oaks, Pa.-based asset management company that offers money-market funds.

McGonigle also notes that if the Fed spaces out its upward moves, rather than move in rapid succession as it did during last year's rate easing, money market funds might have time to rectify their yield disadvantage. "If a money fund has a very short average weighted maturity, it won't take very long for that fund's yield to be competitive with overnight instruments" after a Fed hike, he says. He adds that treasurers assessing money funds should keep an eye on that maturity and whether the funds are in a position to respond quickly to Fed hikes.

If investors do move out of money funds, McGonigle expects they'll have an interest in repurchase agreements backed by government and federal agency securities, because of the safety factor. The rise in rates might also spur the buy-side to be more sensitive to big expense ratios, says Michael Sheridan, director of investments at the Reserve Funds, which has 15 money-market funds. "They'll look at who's charging 25 or 35 basis points, and it becomes a tougher sell," he says.