The sovereign debt crisis in Europe is coupling with the general malaise in financial markets to make life easier for tax-free money market funds by boosting key short-term interest rates.

The higher rates have given taxable money funds a more attractive variety of paper to buy to deliver better yields to clients.

Why should better yields on taxable money funds make any difference for tax-free money funds?

For much of the past year, rates on everything from commercial paper to Treasury bills were so puny that taxable funds were looking for unorthodox places to pick up extra yield.

That lured many of them to tax-exempt variable-rate demand notes and some of the other products that are traditionally the exclusive domain of tax-free funds.

The new competition from taxable funds helped drag down short-term tax-exempt rates and create a drastic scarcity of paper eligible for purchase by tax-free money funds.

The increase in short-term taxable rates — most notably the London Interbank Offered Rate — in the past six weeks has coaxed many taxable funds off the tax-exempt fund industry’s turf and back into the taxable market, fund managers say.

That has eased conditions and helped lift yields — if only a little — enabling tax-free funds to offer better returns to investors.

“For the last nine months to a year, taxable money market managers have been looking at that crossover rate and have been buying more munis than they ever have,” said Craig Mauermann, who manages the $900.6 million Marshall Tax-Free Money Market Fund at M&I Investment Management.

“As we started to see that tick-up in Libor, that caused some of those taxable buyers to go back to [taxable] Libor-based floaters,” he said.

Money market funds act as the equivalent of cash for investors by investing in highly liquid and safe paper.

These funds are broken into “taxable” and “tax-free” categories.

Taxable funds typically invest in short-term bank debt, commercial paper, agency debt, repurchase agreements, Treasury bills, and other secure, short-term taxable instruments. Tax-free funds invest mainly in floating-rate notes issued by government entities whose debt is exempt from taxes.

At the end of March, money funds managed $2.93 trillion, according to the Federal Reserve. They managed $368.7 billion in municipal securities, or 13% of outstanding state and local government debt.

The industry’s troubles since early 2009 are manifold.

The Fed has pinned its target for short-term interest rates to essentially zero — a range of zero to 25 basis points for the federal funds target rate— bringing other short-term rates down in concert.

Those low rates have been exacerbated by the implosion of many banks’ credit ratings. In order to be eligible for purchase by money funds, the floating-rate notes sold by governments typically need a guarantee from a high-quality bank.

The credit crisis batted many of the biggest writers of letters of credit for municipal variable-rate demand obligations out of the “high-quality” category and thus out of the market.

The resultant shortage in liquidity facilities for municipal VRDOs led to a substantial decline in paper eligible for purchase by tax-free money funds.

In the 15 months ending in December 2008, state and local government bodies sold $142 billion in short-term variable-rate debt, according to Thomson Reuters. In the 15 months ending May 2010, they sold $39.2 billion — a decline of 72%.

Things were even tougher in the taxable money fund industry.

Many of the products taxable money funds buy pay rates tied to Libor and at the beginning of the second quarter, one-month Libor was 0.25%.

By comparison, an index maintained by the Securities Industry and Financial Markets Association representing yields on weekly municipal VRDOs was at 0.39%.

So, it made eminent sense for taxable fund managers to encroach on the tax-free funds’ territory and buy muni VRDOs. Mauermann estimated some taxable fund managers at one point held as much as a quarter of their assets in tax-exempt VRDOs.

All this combined to bring tax-free money fund rates down to as low as 0.02% earlier this year, according to iMoneyNet.

These rates were not appetizing. At the beginning of the second quarter, the average tax-free money fund yielded 0.04%. The one-month Treasury bill yielded 0.16%.

Even in the top tax bracket, an investor could out-earn money market funds simply by buying short-term Treasury debt — widely considered the world’s safest investment.

Investors responded accordingly. They withdrew money.

According to the Investment Company Institute, investors ferried $857 billion out of money funds from the beginning of 2009 through the end of the first quarter this year, including $125 billion from tax-free funds.

Many money fund complexes had to waive the fees they charge investors. Federated Investors, which managed $272.3 billion in money market assets at the end of March, reported a 12% decline in income last year, primarily because the Pittsburgh-based company waived $117 million in fees for managing money funds.

If Federated had charged the fees, returns on its money funds in some cases would have been zero or even negative.

Then, the world started to panic over Greece.

Investors started to worry about which banks in Europe had exposure to debt issued by countries like Portugal, Spain, and Italy. Some banks had to pay more to borrow money, which lofted Libor higher because the rate reflects how much it costs a high-quality bank outside the U.S. to borrow dollars.

Three-month Libor spiked 19 basis points in May, to 0.54%. Numerous other rates followed. For example, high-quality one-month commercial paper jumped 12 basis points to 0.37%.

European banks’ funding troubles helped taxable money funds both indirectly — by punching Libor higher — and directly. According to a Crane Data estimate, money funds hold about $400 billion in commercial paper and certificates of deposit from European institution, many of which now carry higher yields.

In its monthly commentary, Crane Data said the slight improvement in yields has apparently allowed some fund families to reduce their fee waivers.

The boost in yields combined with low absolute yields on short-term bonds and a stock market increasingly prone to stomach-turning lurches have slowed outflows from money market funds.

Tax-free money funds are now coughing up cash at a rate of around $700 million a week based on a four-week average. That compares with a pace of $2.9 billion a week in early May, a $3.6 billion pace in late March, and a $4.4 billion pace in early February. Tax-free funds bled an average of $1.8 billion a week in 2009.

“With the concerns over the Eurozone debt crisis and the weak economic domestic backdrop, it’s keeping money sidelined into conservative asset classes,” said Peter Yi, director of money markets at Northern Trust, which manages $21.6 billion in money market assets. “A lot of money market investors in the asset class are there because they can’t weather volatility.”