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Analyzing Money Market Funds: Low Risk Isn’t No Risk

In uncertain times, even relatively low-risk investments come under strict investor scrutiny. And well they should, since they are viewed as a safe haven for hard-earned savings.

Money market mutual funds are considered by many to set the standard for low-risk, liquid and convenient investments. As such, they must be able to stand up to investor questioning.

What should you look for in a money market fund? A basic understanding of the fundamentals of money market fund structure, regulation and management will help answer that question.

Risk

Is there any risk in investing in money market mutual funds? Yes, but all investments carry risk, making a relative risk comparison important. Risks even differ among money funds. Money market funds, unlike bank money market accounts, are not insured. The share price of a money market fund is $1; the yield in effect is the return. The yield may be affected by the default of any securities the fund invests in or changes in the value of investments caused by changes in interest rates; if these factors are severe, the share price of a fund could drop, as well, although no money fund to date [1991] has gone off the $1/share price. Editor’s Note: According to BankRate.com, there have been only two cases in which money market funds have “broken the buck,” or failed to maintain the $1 share price. The first involved the Community Bankers U.S. Government Money Market Fund, which was liquidated in 1994 at 96 cents on the dollar. It was an institutional fund and no retail investors lost money. The second failure was Reserve Primary Money Fund, which broke the buck in 2008. Reserve was the nation’s first money market fund; investors eventually received 99.1 cents per share. The U.S. Securities and Exchange Commission (SEC), under the authority of the Investment Company Act of 1940, regulates money market funds to minimize these risks.

Default risk for money market funds is controlled by strict limits on the quality of issues that money market funds can invest in. Currently, money market funds can only invest in “high quality” securities ranked in the top two categories by national rating organizations such as Standard & Poor’s and Moody’s. Thus, money market funds are prevented from going after higher yields by investing in lower-rated, more-default-prone securities. Default ratings, however, are not guarantees and in some instances have proven to be less than perfect.

Interest rate risk for money market funds is controlled by limits on the maturities of the issues held in a money market fund. Interest rate risk is caused by the price volatility fixed-income investors face when interest rates change: When rates rise, fixed-income prices fall and when rates drop, fixed-income prices rise. The longer the maturity, the greater the price volatility; if interest rates rise, the prices of longer maturity securities fall more than shorter maturities. Money market funds are constrained by maturity rules. Only securities with a remaining maturity of one year or less can be held by a money market fund. To further reduce interest rate risk, the dollar-weighted average portfolio maturity can be no longer than 120 days.

In the future, most of these risk-limiting rules are only likely to tighten. For example, the SEC is currently proposing that the amount of second category default rating securities be very limited and that the investments in the lower rank must be carefully diversified. Another proposed change is that the dollar-weighted average maturity of the portfolio be reduced to a maximum of 90 days, although the maturity of any one security would be allowed to extend out to two years. Whether these proposals are eventually enacted or not, the trend is clearly toward requiring money market funds to further reduce default and interest rate risks.

Judging Risk: Maturity Schedules

How can you judge the relative risk of a money market fund? There is no one number or label that summarizes money market fund risk, but you can look at the general mix of securities, the quality rankings of the securities and the maturity of the fund as discussed generally in the prospectus and specifically reported in the money market fund’s annual report.

Is the reporting standardized, easily comprehensible to the average investor? No, but with a few basic tools and definitions, you should be able to decipher differences among funds.

Examples from annual and periodic reports can illustrate the problem of interpretation and also serve to explain necessary fundamentals. Table 1 provides two examples that report weighted average maturity and the percentage portfolio breakdown by maturity. The fewer investments in the 181- to 365-day maturity breakdown and the more investments in the 1- to 30-day maturity range, the less volatile the portfolio. Weighted average maturity should be low, less than 60 days, if interest rate risk is an important consideration, but the dispersion of maturities is also important, particularly if the new SEC proposal (extending the maximum maturity to two years, while reducing the maximum weighted average maturity to 90 days) is implemented.

Another maturity consideration is changes in weighted average maturity period-to-period. Consistent average maturities translate to lower risk because wide swings in average maturity imply that fund management decisions are being made based on attempts to enhance yields. This means the fund may attempt to go after higher yields in longer maturities when available, or to raise average maturity when interest rates are expected to decline and lower average maturity when rates are expected to climb. However, errors are the norm when forecasting interest rates, and errors can adversely impact liquidity and returns.

Judging Risk: Default Information

The risks inherent in different security categories and the relative default risk within a category are equally important. Unfortunately, the presentation of this information in a prospectus is usually not very well detailed, and the few details that are provided in some annual reports can be confusing.

Table 2 provides examples of approaches used in three different fund reports. In the first example, the T. Rowe Price Prime Reserve Fund reports portfolio diversification in a rather hodge-podge manner. Types of investments—certificates of deposit, for example—are mixed with industries—such as petroleum. In order to get an idea of what the fund is investing in, a look at the statement of net assets, which also appears in the annual report, would be required. The statement of net assets lists each investment held by the fund, with some details concerning maturity, interest rates, and the amount held by the fund. Fortunately, the statement includes a summary of the investments by type—i.e., certificates of deposit, commercial paper, etc.—and gives the percentage of the portfolio invested in each. For the T. Rowe Price Prime Reserve Fund, this statement indicates that, as of 2/28/90, 70.2% is invested in certificates of deposit, 28.1 % is in commercial paper and the 1.7% remaining is in miscellaneous investments.

The second example, the portfolio summary format produced by Fidelity, is much more useful—listing portfolio composition by type of security. But how can you judge the different risks of funds with different mixes of security types? It is helpful to simply understand what these security types are and how to classify them.

Funds can be classified generally by the types of investments they make. The lowest default risk funds are those that invest only in U.S. Treasury securities or repurchase agreements against them. U.S. Treasury securities are Treasury bills and Treasury notes. Repurchase agreements are temporary purchases of securities with an agreement that the seller, perhaps a bank dealer in U.S. government securities, will repurchase them at a specified future date and price. The U.S. Treasury securities are held as collateral, so the ultimate risk of default is essentially zero.

Moving up on the risk ladder, the next category of money market fund would be those that also invest in the securities of federally sponsored agencies such as the Federal Farm Credit Bank and Federal Home Loan Bank.

The next risk rung on the ladder are those funds whose holdings include prime domestic investments such as certificates of deposit or highly rated commercial paper. Commercial paper is short-term, uncollateralized IOUs of corporations. The SEC restricts money market funds to investing in only highly rated commercial paper and, unlike U.S. Treasury securities and agency securities, commercial paper can default, but only rarely has this occurred. Domestic medium-term notes are commercial paper issues with longer maturities.

Certificates of deposit held by money market funds are of the large and negotiable variety and have risks similar to commercial paper. Because of their size, the certificates of deposit that funds invest in do not enjoy any deposit insurance and your risk is the risk of the bank issuing the certificate.

The top rung on the risk ladder would be funds whose holdings include bankers’ acceptances and Euro and Yankee securities. Bankers’ acceptances are, generally, bank guarantees of a firm’s debt arising from import or export business; these instruments are as risky as the bank issuing the acceptance. International investments can take place in any of the security types with the obvious exception of U.S. Treasury securities. Other ways of distinguishing international fund investments are the terms Eurodollar or Yankee dollar investments. For example, a Euro CD is issued by a branch of a U.S. bank in a foreign country or a foreign bank, and is usually denominated in dollars. A Yankee CD is a CD issued in the U.S. by a branch of a foreign bank.

While this risk ladder (summarized in Table 3) appears clear-cut, many funds can invest in all these types of securities, and the proportion of the portfolio that is actually invested in each is critical. Also, maturity, as mentioned, must be considered a risk factor, with longer-weighted average maturities differentiating risk even within a category.

One other approach to the problem of detailing default risk is provided by the third example in Table 2. In this instance, Dreyfus New York Tax-Exempt Money Market Fund has summarized portfolio investments by rating category. Moody’s and Standard & Poor’s are the two major rating agencies and they usually agree, giving equivalent ratings; split decisions, however, do occur.

The first two ratings categories are actually bond ratings, used when the notes are not rated but the bonds are. These are the top two bond category ratings. The MIG1 (Moody’s Investment Grade 1) and SP1 (S&P 1) are the highest ratings for municipal notes. The P1 and A1 ratings are the highest for tax-exempt commercial paper. Securities not rated are usually claimed to be comparable to the rated securities in quality.

Table 3. Money Market Fund Investments: Climbing the Risk Ladder

Type of Security (Listed From Lowest to Higher Risk)

U.S. Treasury Securities; Repurchase Agreements Against Them: U.S. Treasury bills and notes, and repurchase agreements with U.S. Treasury securities held as collateral. Repurchase agreements are temporary purchases of securities with an agreement that the seller will repurchase them at a specified future date and price.

Federally Sponsored Agency Securities: Securities issued by a federally sponsored agency such as the Federal Farm Credit Bank and Federal Home Loan Bank.

Prime Domestic Investments: Certificates of deposit or highly rated commercial paper. Commercial paper is short-term uncollateralized IOUs of corporations.

Bankers’ Acceptances; Euro and Yankee Securities: Bankers’ acceptances are bank guarantees of a firm’s debt arising from import or export business. Euro securities are securities issued outside of the U.S, by a branch of a U.S. bank in a foreign country or by a foreign bank, and usually denominated in dollars. Yankee securities are securities issued in the U.S. by the branch of a foreign bank.

What should this rating summary mean to you? You already knew that money market funds can only invest in the two highest-rated categories, and this confirms the rule. Second, if you add up the highest-rated category, Dreyfus has invested 84.6% of the portfolio in securities with the highest rating, lowest default risk as assessed by the two national rating agencies. The lower the percentage invested in the highest category, the higher the risk.

The Bottom Line

Beyond the different operating costs of funds, which are detailed in the prospectus, yield differences can be attributed primarily to risk; the lower the default risk and/or the shorter the average maturity, the lower the yield.

Because of SEC rules, these risks are minimized, but not eliminated. If you remain uncomfortable with the relatively higher risk funds, even after understanding fund investment rules and security risks and remembering their absolute risk is still low, then it would be worthwhile to give up that half a point to one percentage point of yield and stay with a U.S. Treasury-only fund.

This article was written by John Markese for the March 1991 issue of the AAII Journal. At the time, Markese was executive vice president and director of research at AAII. He is also a former president and the current chairman of AAII.

 

 

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