Liquidity Lowdown: Not all investments in MMFs are created equally

Money market funds (MMFs) are not designed to be growth investments. They are designed to be secure, highly liquid funds aimed at providing a safe place for investors cash, especially in times of market stress or uncertainty. 

But here’s the catch: not all investments in MMFs are created equally, and chasing the highest yielding MMF can sometimes lead to unintended risks.

Additional yield, when derived from riskier assets, may not justify the overall increased risk

Deriving yield from riskier assets

Cash investments are often thought of as risk-free, and while they do carry lower risks than investing in bonds or equities, they are not immune to risk. It can be tempting for investors to chase the highest yielding MMF, but that additional yield, when derived from riskier assets, may not justify the overall increased risk to the investor’s principal and appetite. Above all else, protecting an investors principal should be the primary concern when investing in an MMF. We believe an MMFs purpose is clear – to deliver capital preservation, liquidity, and yield.

But what does this actually mean in practice?

Often, higher yielding cash instruments will be issued from lower rated financial institutions. In order to attract funding from investors, those issuers need to offer higher levels of interest. Although the likelihood of an issuer defaulting in an MMF is generally very low, this risk tends to rise as you move down the capital structure and towards issuers and financial institutions with weaker credit quality. History still firmly reminds us of the 2008 financial crisis, when multiple UK deposit-taking institutions failed, alongside numerous smaller financial firms which have since followed suit. However, investing in the highest quality issuers in the market ensures the most effective way to minimise one of the most important risks (risk of default) in an MMF.

Asset-backed commercial paper (ABCP) and its pitfalls

Cash instruments offering higher yields can sometimes derive from assets with limited liquidity. ABCPs are short-term debt instruments, found in many MMFs. They are issued by a special purpose vehicle, which purchases a pool of assets that acts as collateral for the underlying commercial paper issuance. However, our view is that ABCP carries liquidity risk with a subdued secondary market when compared to other money market instruments. This is even more stark in times of stress in the market. ABCP can often look attractive on the outset – short maturities, asset backing and competitive yields – but in our view, the liquidity risk it carries make it vulnerable. During the 2008 financial crisis ABCP markets collapsed. They played a central role in the crisis acting as a key conduit for spreading risks from the subprime mortgage market into wider financial markets. There is often a perception of safety when it comes to ABCP, but investors often have limited visibility into the pool of underlying assets, and complexities in structures can obscure true risk exposure.

We feel that the most optimal way for investors to utilise an MMF is to look at the assets comprising the fund and consider the risks they are taking

The risks associated with some regions

MMFs maintain high levels of diversification to spread risk through a combination of investing in different asset types and geographical locations. But certain geographical locations are prone to additional challenges making them less attractive. Japan faces a number of structural problems that have persisted for decades – record high debt, acute labour shortages exacerbated by demographic trends, and weak economic growth – mean Japan faces difficulties. Levels of inflation remain elevated by historical standards and are substantially higher than where they were pre-pandemic, with further rate hikes expected. Japanese banks that are active in money markets are typically lower rated than banks from other regions, such as Canada. As such, money market instruments issued by Japanese banks offer higher levels of interest to attract funding, but we believe that while MMFs should consider some limited exposure to this region to maintain diversification, it may be imprudent to have a substantially high exposure to a region where some parts of the economy remain weak.

We feel that the most optimal way for investors to utilise an MMF is to look at the assets comprising the fund and consider the risks they are taking. Yield derived from high quality assets which have been bought when they are relatively cheap, is a far more sensible way of adding incremental yield, rather than investing in assets that are generally riskier in nature. Chasing higher yields can mean taking on disproportionate risk. In MMFs, the safest return is simply the return of your principal.

For professional investors only. This material is not suitable for a retail audience. Capital at risk. 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.