Assets in money market funds (MMFs) have soared to record levels, drawing investors with their safe haven appeal and yield advantage over bank deposits.
Over time, the sub-sector has become top heavy - it’s the nature of markets to concentrate into a few hands. Only five players account for 70 percent of the total asset under management. Is this a real vulnerability?
Let’s make sense of this issue. The MMF sector has over the years enjoyed mainly net inflows. Simply put, outflows have generally not surpassed inflows on any extended basis.
As a result, MMFs have grown to account for about two-thirds of all funds under management by collective investment schemes as at Q1 2024.
With the concentration at the top, it means the over two dozen MMF schemes (small to mid) will have to explore ways to stand out. Posting that “extra yield” will be one of the ways to do so.
Hypothetically, the current 5.5 percent yield differential (this is not a sector weighted average yield) between the best and worst performers - some returning less than official interest rates - should expand further as a result. And this is where troubles may begin.
Most are likely to fall into the temptation to invest in high-yielding instruments (read commercial paper, asset backed securities, special investment funds, etc.) which could plunge them into ruin.
It only takes a stressful market event or even a change in direction of flows leading to sudden and large redemptions. While typical fund redemptions are done via maturing assets rather than asset sales, in stressful terms, MMFs may be forced out of positions mostly at a discount.
It’s these extreme liquidity pressures that may see NAVs fall below a shilling - meaning investors lose money they had initially put in - as funds struggle to sell high-yielding assets with little or no secondary market trading.
Gating withdrawals, as has happened before in the industry, or even placing high redemption fees, could cause serious damage to investor confidence.
Maturity and concentration limits as stipulated by the regulator may do little to curb damage. This phenomenon is what is famously known as “breaking the buck.”
Runs on money market funds have been rare. However, the risk remains since tail events, although hard to predict, do happen. A good example is the pandemic season in 2020. It is recorded that the US government had to put in place credit facilities to support money market funds.
This prompt intervention helps explain the vulnerabilities of MMFs and the need to put in place measures to counter such stresses.
Another example is the Reserve Primary in the US in 2008. This MMF, eager to keep ahead of the competition, was over-exposed to commercial paper issued by failed bank Lehman Brothers.
It had a large enough exposure that marking those assets down made them unable to maintain a stable one dollar share value. All this to say, in a field full of players eager to impress the investing public, disruptive redemptions are a real possibility, they only need a trigger. For this, investors should be aware and discerning.
The writer is the Managing Director, Canaan Capital Limited.
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