Liquidity lowdown: getting paid (or not) for credit risk

Money market funds (MMFs) have been pretty flush with cash since the start of the year. With the continued uncertainty over the timing of rate cuts by central banks, much of this cash which has flooded into these funds has so far remained in-tact.

Of course there are many predictable outflows from MMFs each month – payrolls and general operational costs see cash being drawn down, but recent indications from the Federal Reserve (Fed) has suggested that officials are in no hurry to start cutting rates. Given the Bank of England (BoE) have lagged behind the Fed from the start, this somewhat suggests that MMFs are still holding onto the significant amounts of assets they have accumulated for a good reason. This is not to say that the BoE cannot cut rates before the Fed, but we see this scenario as unlikely. 

Nonetheless, despite being so flush with cash, investors are almost having to accept to skimpiest compensation for credit risk on certificates of deposits (CDs) at present, a common asset in any MMF. Ever since markets started pricing in rate cuts at the end of 2023, credit spreads have been squashed and the additional yield an investor receives on a CD over government debt for example, has narrowed significantly. Better credit quality generally attracts tighter spreads, and with the economy recovering somewhat and the recession which materialised in the final quarter of 2023 practically forgotten about, it is reasonable to assume spreads would naturally grind tighter. Coupled with the huge buying demand from MMFs at the start of the year following large inflows, issuers have found themselves with little appetite to issue CDs at levels once deemed attractive to MMFs. For investors, the problem is that the tighter the spreads go, the greater the potential losses following a significant upwards shift in spreads, should that indeed materialise.

In March 2024, there has been little change in the yields being offered on CDs. The continued lack of appetite for longer-dated cash from issuers and stubborn market pricing explains this. Ordinarily, investors expect an additional level of compensation for lending out cash for a longer period of time – after all, there is more uncertainty the further you go into the future. However, we don’t currently see this in money markets. In fact, as you extend out from a six-month to a one-year CD, the yield is actually lower, reflecting the market expectation that rates will eventually be cut, most likely later in the year. The curve is somewhat downwards sloping, but it is marginal. The worry for investors now is what happens if the BoE do not cut rates this year. It’s an unlikely scenario, and most of the data which the BoE has been watching closely points to the first cut coming later this year, some suggesting as early as June. We expect inflation to fall either to target or even below in the coming months due to falling energy prices, but a scenario where the BoE does not cut rates this year, however unlikely, cannot be totally discounted.

So with tighter credit spreads, and CDs remaining relatively expensive, where can we find value in money markets instruments? Currently, we are seeing better value in short-dated government debt, or treasury bills (T-bills). There is always plenty of demand in the weekly auction, and the yields on offer do not lag far behind those seen on a CD of the same tenor. In our view, this indicates that investors are just not getting paid to take credit risk. T-bills offer not only superior liquidity, but as government paper, returns are seen as risk-free and in times of credit stress, investors will often run for the perceived safe haven of government debt – inevitably pushing up its price and to some degree, potentially mitigating credit losses. As such, we think this is an interesting area at the moment, at least until there is more appetite from banks and financial institutions to borrow cash from MMFs over any period of time. We do however see a continued demand for very short-dated securities or overnight cash. MMFs typically lend large amounts of cash to banks and financial institutions on an overnight basis, in order to meet their daily and weekly liquidity requirements. Several banks were offering better levels on overnight deposits in March when compared to February, suggesting that the short end of the cash market is functioning well. That will come as some relief to investors should the new increased daily and weekly liquidity requirements come into force from the FCA later in the year. But for now, and despite the first rate cut looming, money market funds are still hanging onto some of the highest yields they have seen for well over a decade.

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.