This is an extended version of the article that appeared in the October 2012 issue of Investment Advisor.
Good ol’ money-market funds—the ultra low-risk, pretty-much-the-same-as-cash-plus-a-dividend funds that offer investors liquidity and a respite from market volatility. They’ve been go-to funds for decades, but in recent years just about everything in the investment world has changed and money funds are no exception. It’s not that the funds themselves have changed; it’s the dynamics in the marketplace.
Money funds are still used primarily to reduce portfolio risk by limiting exposure to asset markets and to maintain liquidity. Regulations haven’t changed (yet) either. Rule 2a-7 of Investment Company Act of 1940 restricts the quality, maturity and diversity of investments by money-market funds, which may invest in commercial paper, repurchase agreements, short-term bonds and other money funds. Money funds are required to invest primarily in the highest rated debt and maintain a weighted average maturity of 60 days or less and invest no more than 5% in any one issuer, except for government securities and repurchase agreements. They seek to maintain a stable value of $1 per share and pay dividends to investors, which emphasize their relative safety.
Historically Low Yields
Returns on money funds are at zero and any improvement seems impossible in the near-term. This has driven some investors to FDIC-insured CDs and interest-paying bank accounts. Of course, these vehicles can be cumbersome and aren’t as liquid as money market funds, but with no immediate sign of higher interest rates and continued uncertainty around stocks and bonds, investors aren’t demanding as much liquidity as they have in the past.
Interest rates on money funds’ underlying investments have been just a whisper above zero for several years now, and many funds have been forced to shut because there’s no profit to be had. Many of the funds still operating waive or drastically reduce their fees just to avoid “breaking the buck.”
Thankfully, over their almost 40-year history, only a few funds have broken the buck. After the Reserve Primary Fund did so in September 2008 as a result of the Lehman Brothers bankruptcy, it became clear that the risks of investing in money market funds are real. Regulators have been talking about reforming the rules around money market funds, but have taken no real action, despite several warnings from those in the know.
In an April 9 article in The Wall Street Journal, Kristina Peterson and Michael Derby reported comments from Federal Reserve Chairman Ben Bernanke that highlighted his concern. At a conference, he said, “The risk of runs created by a combination of fixed net asset values, extremely risk-averse investors and the absence of explicit loss-absorption capacity remains a concern. Additional steps to increase the resiliency of money-market funds are important for the overall stability of our financial system.” He also said that the repo market, where dealers finance their bond-trading positions, is a source of concern. He suggested that if there were a default of another major financial institution, the repo market could be exposed to some serious risks. This was at least the second time the Fed chairman made such comments publicly.
In the May 2012 issue of PIMCO’s Viewpoint, Jerome Schneider, a fixed income portfolio manager at the firm, wrote, “We believe there are three ‘plumbing’ issues short-term investors should constantly monitor during 2012 and beyond, because they will likely affect the performance of their cash management portfolios. The operational and funding components of our financial system – repurchase, or “repo,” agreements, collateral posting and funding transactions of collateralized and uncollateralized natures – are now important indicators of whether investors can expect to bathe in the warm waters of liquidity or suffer from unheralded waves of credit risk or ebbs in liquidity.
“Repurchase agreements are usually over-collateralized borrowings in which the holder of securities sells the securities to an investor with an agreement to repurchase them at a fixed price on a specified date. In the [United States], recent efforts by the Federal Reserve and the Securities and Exchange Commission to review the inner workings of the repo markets and money market funds only serve to highlight the importance of these pipes of liquidity and credit creation. However, this is a truly global problem that needs consideration and action by investors and regulators alike.”
Some observers are concerned that fund companies are being compelled to reach for yield. On its own, a repo is a simple and straightforward transaction, as long as the borrower has the ability to repurchase the collateral. Repos can also be manipulated in a way that creates leverage for banks. One of the main reasons MF Global failed was so-called “repo-to-maturity” transactions, which extended the repurchase date far into the future, thus increasing the risk of the transaction. Repos also played a key role in the failures of Bear Stearns, Merrill Lynch and Lehman Brothers.
The risks realized by investors in the Reserve Primary Fund, which broke the buck after writing off debt issued by Lehman, could have been felt in other funds, and most certainly would have if the Lehman default would have resulted in a run on the shadow banking system. Redemptions from money market funds result in a drop in demand for commercial paper, which may prevent companies from rolling over their short-term debt and potentially cause a liquidity crisis. In such a scenario, if companies cannot issue new debt to repay maturing debt and do not have cash on hand to pay it back, they will default on their obligations and may have to file for bankruptcy. Thus, a run on money funds could cause extensive bankruptcies and a debt devaluation spiral.
Of course, we can speculate about how markets might react in any number of situations. Such thought experiments are certainly healthy. The point is, given the observable risks—to say nothing of the unknown risks that hide in the dark corners of the shadow banking system—combined with the fact that returns on money funds at historic lows, it would be wise to consider some alternatives.
Money Market Alternatives