How Is Recent Volatility Affecting Money Market Funds?
Presented by Dean Elliott:
Over the past weeks, the U.S. equity markets have experienced a substantial downturn due to the global spread of the coronavirus. Even some U.S. bond investments, which are typically assumed to be a safe asset class, have been affected. Accordingly, the focus of many investors has turned to money markets and true cash holdings. This article reviews the unique features of money market funds and some of the concerns investors may have about this asset class. It also covers the current steps the federal government is taking to support this sector of the market.
Money Market Fund Defined
A money market fund is not a bank account. It’s a type of mutual fund that invests in high-quality, short-term securities with a minimum level of risk. The dividends paid by money market funds are typically higher than bank interest rates. Investors benefit from a low level of risk and can usually withdraw funds quickly, an advantage known as “liquidity.” Because money market funds are offered by an investment fund company, rather than a bank, they are not guaranteed by the Federal Deposit Insurance Corporation (FDIC).
The Different Types of Money Market Funds
There are many types of money market funds, but they are primarily categorized as follows:
- Prime money funds that primarily invest in corporate and government-sponsored commercial paper (CP)
- Government money funds that primarily invest in cash, government securities, and other securities collateralized by cash or the U.S. government
- Treasury money funds that primarily invest in U.S. Treasury bills, bonds, and notes
- Tax-exempt money funds that primarily invest in municipal bonds
Some funds are intended for individual (or retail) investors, while others are intended for institutional investors.
Over the past weeks, you may have heard CP come up in the news. CP is a form of short-term debt offered by large corporations. In essence, it provides credit lines that corporations rely on to pay for their short-term cash needs. The time frame to maturity for CP is typically 30 to 90 days. The buyers for CP include large corporations, banks, and prime money market funds. Due to the current financial disruption, these buyers have been stepping back from the CP market to preserve their own cash liquidity. As a consequence, the borrowing rates for CP have spiked.
That spike is bad for the corporations that need to borrow money, but the issues surrounding CP should have a limited impact on investors in money market funds. First, of the more than $1.13 trillion CP market, money market funds hold just over 1.5 percent of the asset class not issued by banks.* That’s just a fraction of the CP held by money market funds during the global financial crisis of 2008. Furthermore, the Federal Reserve (Fed) announced on March 17 that it will open a special credit facility to purchase CP from corporations that cannot find buyers on the open market.
Mutual Fund Credit Program
This emergency credit program, rolled out by the Fed on March 18, is intended to provide money markets with liquidity, in case this becomes scarce. It will prevent mutual funds from having to sell assets at a discount if there is a sudden surge in withdrawals from individuals or firms. Typically, the might of the U.S. government stepping in with support would be regarded as a positive. In the current environment, however, you may be asking, “Just how bad is this crisis if the Treasury Department needs to step in?”
Details on the emergency credit program remain scant, but it appears consistent with the suite of strong measures the government is employing to protect the U.S. economy and calm the equity markets. Furthermore, this action seems directed at the category of prime money market funds intended for institutional investors, rather than funds for individual investors.
If you’re concerned about an investment in a prime money market fund, you might consider moving your assets to a government fund. Unlike a prime fund, a government fund invests primarily in cash and securities collateralized by the U.S. government. Accordingly, government funds offer investors lower risk than prime funds.
Mutual Fund Risks
Of course, mutual funds come with risks. These include “breaking the buck,” liquidity fees, and redemption gates. These topics sound scary, so let’s put them into perspective.
Breaking the buck. This term refers to a situation in which the share price of a money market fund falls below its stated $1.00 net asset value (NAV). In general, a mutual fund’s NAV represents the total value of its assets minus liabilities as a per-share price on a specific date. With money market funds, the aim is to maintain a stable NAV of $1.00 per share. Excess earnings are distributed to investors by way of dividend payments.
During the 2008 financial crisis, the NAV of a major money fund did drop below $1.00, thus breaking the buck. Since then, however, government regulations have been enacted to prevent another such occurrence. In particular, government funds and funds intended for individual investors are designed to maintain the $1.00 NAV. The emergency credit program discussed above should support this share price. Dividends, however, are likely to go down due to the current rate environment.
As for prime funds targeted to institutional investors, they can have a “floating” NAV that varies based on price fluctuations in the underlying holdings. This NAV is typically priced to the fifth decimal point (1.00001), so the variance tends to be very small.
Liquidity fees and redemption gates. Prime funds (for both individual and institutional investors) are permitted to impose liquidity fees and redemption gates. A liquidity fee is an extra fee that can be charged when shareholders withdraw funds. A redemption gate is a temporary restriction on withdrawing funds during times of extraordinary financial stress. To be fair, neither liquidity fees nor redemption gates have been imposed as of this writing (March 26, 2020). Even though these occurrences are unlikely, you should be aware of them.
In summary, here are the primary considerations you should be aware of:
- Government funds will maintain a stable $1.00 NAV. They are not subject to liquidity fees or redemption gates.
- Prime funds for individual investors will maintain a stable $1.00 NAV. They may be subject to liquidity fees or redemption gates.
- Prime funds for institutional investors may have a floating NAV. They may be subject to liquidity fees or redemption gates.
An Investor Action Plan
Let’s review a possible scenario that could help you develop an action plan. Let’s say you’re holding a prime money market fund because the dividends were higher than those offered by a government fund or the interest from a bank account. Due to current events, you’re concerned about the risks of your shares dropping below $1.00 or not being able to withdraw your cash when you need it. You want to reduce your risks. To do so, you could consider moving your money from your prime fund to a government fund. The dividends from a government fund may be lower, but you won’t need to worry about share price, liquidity fees, or redemption gates. Lower dividends might be worth removing those items from your list of concerns.
In another scenario, you may want to entirely remove your savings from money market funds. In this case, you could move your funds into a bank sweep program. Commonwealth’s Bank Deposit Sweep Program (BDSP) places your cash in participating banks, thereby providing you with the benefit of FDIC insurance (subject to terms and conditions). In addition, interest income is typically generated. The difference in return between a government fund and the BDSP is about 60 basis points, or 0.60 percent.
Keeping Cash Management in Perspective
Seeing a drop in your investments is scary. But it’s wise to keep current market conditions in perspective and focus on well-established methods for cash management. Given the strong moves the federal government has made to support our economy, investing in money market funds remains a reasonable strategy—as long as you understand their unique features.
This material is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.
Dean Elliott is a financial advisor located at Global Wealth Advisors 209 East Mulberry Street, Suite 250, Angleton, TX 77515. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at (979) 849-4700 or at email@example.com.
Authored by Nick Follett, manager, fixed income, at Commonwealth Financial Network.®
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