Published: January 01, 2000
Given treasury professionals’ sharp focus on principal stability, it only makes sense that money market funds have become a staple of corporates’ liquidity-management programmes. Professionally managed and highly diversified, money market funds historically have been among the most liquid and stable investments available. However, the strong track record of money funds should not lull investors into a false sense of security. Money market funds can be vulnerable to market disruptions – some more than others because portfolio risk varies from fund to fund. As such, treasury professionals need to carefully vet funds’ investment risk to ensure a fund manager’s risk appetite aligns with their risk tolerance.
When evaluating a money market fund’s ‘risk’, the investor must assess three types of risk – credit risk, liquidity/redemption risk and interest rate risk. The major drivers of performance and portfolio volatility, these risks can be difficult to analyse because they are increasingly interconnected. That said, it is vital to conduct at least a rudimentary analysis of these risks when screening funds. This is especially true in the current low-rate environment, which could encourage fund managers to take on additional risk to help boost yield.
In the fixed income space, credit risk refers to the probability of an issuer defaulting on principal or interest payments or of suffering a credit rating downgrade that would decrease the value of its outstanding debt. A money market fund’s credit risk is a function of the credit quality of its individual holdings. A fund with a heavy allocation to US Treasuries, US federal agency debt and AAA-rated corporate debt typically would be considered less risky than a fund with a smaller allocation to those securities and a larger exposure to credits with a higher risk of default or downgrade.
The risk of default or downgrade is but one facet of credit risk. A more arcane element of credit risk is ‘duration of credit risk’. The key measure of a fund’s duration of credit risk is its weighted average life (WAL), which reflects the weighted average final maturity of all the securities in the fund’s portfolio. All things being equal, a money fund portfolio with a long WAL is more risky than one with a shorter WAL because in the event of significant spread widening, the former would be more vulnerable to declines in the prices of its holdings. It also would be less able to quickly re-allocate to more defensive credit sectors.
To gain a sense of how duration of credit risk can impact a portfolio, consider the illustrative hypothetical presented in Figure 1. Fund A has no floating rate notes, investing primarily in a mix of fixed-rate commercial paper and negotiable certificates of deposit. Approximately 85% of its holdings are scheduled to mature within 90 days, and 50% are due to mature in 30 days. Its WAL is 63 days. Fund B has the same credits but features a ‘barbelled’ structure with 75% of the portfolio scheduled to mature within 90 days and 40% set to mature in 30 days. Nearly 25% of the portfolio consists of floating-rate securities maturing in six to 12 months. Its WAL is 104 days. If a market or credit event were to trigger a significant spread widening and loss of liquidity, Fund A would be better positioned than Fund B for several reasons:
Recognising the impact of duration of credit risk on the stability of money market funds, the US Securities and Exchange Commission and the Institutional Money Market Fund Association, which establishes guidelines for funds domiciled in Europe, have limited the maximum WAL to 120 days for registered money market funds.[[[PAGE]]]
Liquidity/redemption risk measures the probability of a fund being able – or unable – to meet investor redemptions when requested. To evaluate a money market fund’s liquidity risk effectively, you must review several key metrics:
Daily and weekly liquidity clearly is important because it provides the cash necessary to meet redemptions. However, absolute levels of available liquidity are not the best metric of a fund’s liquidity risk because that measure does not capture the probability of a significant liquidity drawdown due to large redemptions. The better indicator of liquidity/redemption risk is the ratio of daily/weekly liquidity to the combined positions of the fund’s largest shareholders. Ideally a fund’s daily and weekly liquidity would match – or at least come close to matching – the total assets of a fund’s top three to five shareholders.
The problem one faces when assessing a fund’s liquidity/redemption risk is the lack of transparency with regard to shareholder concentration. Fund managers are not required to disclose the size of their largest shareholders’ investments, making it difficult to evaluate a fund’s vulnerability to large redemptions. Therefore, the best one can do when attempting to gauge a fund’s liquidity/redemption risk is to scrutinise readily available liquidity metrics – daily and weekly liquidity (discussed above), the liquidity characteristics of the fund’s holdings and its WAL.
A fund’s liquidity profile will reflect, to some degree, the liquidity profile of its holdings. If, for example, a fund has a large allocation to widely traded assets for which there is a deep market – US Treasuries and high-quality corporates come to mind – it likely would be viewed as having better liquidity than a fund with large exposures to less liquid assets. (This assumes that other drivers of liquidity – shareholder concentration, for example – are the same for both funds.)
Another important metric of a fund’s liquidity is its WAL, which, again, is the weighted average final maturity of the securities in the fund’s portfolio. Portfolios with short WALs, say 60 days, are likely to have a large exposure to short-dated notes, i.e., those with 30-, 60- and 90-day maturities. Additionally, portfolios with relatively low WALs tend to have less exposure to floating-rate securities, notes that reset to the interest rate of a daily, monthly or quarterly index. Generally portfolios with lower WAL are considered to be more liquid than those with a higher WAL because the securities in the former would be maturing sooner than those in the portfolio with a longer WAL.
To see how redemption risk can vary from portfolio to portfolio, consider two hypothetical funds with the same levels of overnight and weekly liquidity (Figure 2). In Fund A, 50% of the holdings mature in 30 days and 85% in 90 days, while 40% of Fund B’s holdings mature in 30 days and 73% within 90 days. Fund A’s WAL is 60 days, while Fund B has a WAL of 96 days. Fund A has 10% of its assets in US federal agency coupon notes and 10% in non-financial commercial paper. By comparison Fund B has 2% of its assets in US federal agency coupon notes and 3% non-financial commercial paper. In this scenario, Fund A would have lower liquidity/redemption risk because its holdings naturally would be maturing sooner than those in Fund B. Fund A also has larger holdings of the liquid federal agency coupon notes and non-financial paper, giving it the advantage should the funds need to generate cash during a distressed market.
It is particularly important for the managers of institutional money market funds to reset their portfolios because institutional investors tend to react more quickly than individual investors to changes in their funds’ yields. Indeed, a change in yield of just a few basis points can prompt institutional investors to initiate large redemptions to fund purchases of individual securities with higher yields or to invest in higher-yielding funds. Large redemptions can force a fund manager to sell off its shorter-dated securities to meet the redemptions, making it all the more difficult for the manager to reset the portfolio.
Prior to the global financial crisis, most investors believed money market funds were as much a safe haven during volatile markets as US Treasuries. The breaking of the buck by the Reserve Primary Fund and the subsequent run on money funds reminded them that no investment – not even a money fund – is inherently ‘safe’. Today investors should not assume that the stringent risk controls imposed by US and European regulators in the wake of the financial crisis have eliminated risk differentials among funds. The risk appetites of fund managers still vary, and as they weigh their investment options, treasury professionals still need to ascertain the amount and composition of funds’ portfolio risk. To do less is to risk discovering during the next market disruption that their fund manager’s tolerance for risk is not in sync with their own.
Note
[1] Investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments and yields and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices typically drop, and vice versa.
[2] Mutual fund investments are subject to certain risks. An investor’s principal and return will fluctuate with changes in market conditions so that the shares, when redeemed, may be worth more or less than their original cost.
[3] Diversification does not ensure a profit or guarantee against loss.
The hypothetical portfolios are based on historical data and are intended for illustrative purposes only. They are not intended to be representative of future performance or any particular investment.
Opinions expressed in this article are those of the author(s) and may differ from those of Bank of America Corporation and its subsidiaries. BofA™ Global Capital Management is an asset management division of Bank of America Corporation. BofA Global Capital Management entities furnish investment management services and products for institutional and individual investors.
Some products and services may not be available in all jurisdictions or to all clients.
This material is for educational purposes only. It cannot be used for the purposes of avoiding penalties and taxes. BofA Global Capital Management does not provide tax or legal advice. Please consult a tax advisor or tax attorney for specific tax or legal advice. Investments in foreign securities involve special risks, including foreign currency risk and the possibility of substantial volatility due to adverse political, economic or other developments. These risks are magnified for investments made in emerging markets. Global investing poses special risks, including foreign taxation, currency fluctuation, risk associated with possible differences in financial standards and other monetary and political risks.
Bank of America Merrill Lynch Banco Múltiplo S.A. / Merrill Lynch S.A. Corretora de Títulos e Valores Mobiliários – Ombudsman / Ouvidora Toll Free / DDG: 0800 886 2000 | e-mail: ouvidoria_bamlbrasil@baml.com
How Thought Leadership Can Reduce the Cost of Sales by Patrik Havander, Havander & Partners A focused attention on the costs incurred by the global sales and marketing processes is becoming increasingly important for corporate banks and their transaction banking departments. While the client/bank relationship remains vital, research has shown that in fact relationship selling […]
