THE RISKS ASSOCIATED WITH MONEY MARKET INVESTING
Volume 17
Investors need to be well informed about the risks associated with money market investments. The primary objectives of a money market fund
are capital protection and provision of liquidity. Yet during the global credit crisis, it became evident that even money market funds can suffer
capital losses and liquidity constraints.
Prior to the crisis, traditional money market securities were offering low yields and low risk premiums compared to historic levels. This lead to
many managers searching for alternative sources of higher yield such as asset-backed commercial paper (ABCP) with AAA credit ratings at the
time. As it turned out, around 15% of the ABCP market was backed by subprime debt and the widening of ABCP spreads after the subprime crisis
lead to The Reserve Primary Fund, the oldest money market fund in the US, "breaking the buck" or falling below a $1 NAV. Many other funds
experienced significant volatility as the credit crisis progressed, and several managers had to provide capital injections or purchase illiquid assets
from their portfolios to prevent their own money market portfolios falling below $1.
While most investors perceive money market investments to be very low risk or even risk-free, this is by no means the case. In order to target
higher yields, portfolio managers take on additional risk. This additional risk is not always justified by the reward proposition. As such, investors in
money market funds should check that their fund manager has implemented appropriate strategies to mitigate these risks and is following a consistent and disciplined approach when investing in low-risk income opportunities.
There are a number of investment risks associated with money market funds including reinvestment risk, counterparty risk, instrument risk, and
liquidity risk.
Reinvestment risk
Reinvestment risk is the risk of investing maturing funds at a lower interest rate and getting a lower yield than on the maturing investment.
If inflation is rising, the MPC will typically raise short-term rates and vice versa. Although inflation has been rising in the past year, the MPC has
kept interest rates unchanged. This has affected interest rate expectations, resulting in uncertainty and volatility in short-term interest rates. The
task of managing reinvestment risk can be cumbersome if short-term interest rates are highly volatile.
We take advantage of low reinvestment risk opportunities presented by the yield curve, even in times of uncertainty, by investing in short-dated
instruments when the yield curve is flat, or further along the yield curve when it is steep to benefit from higher yields. We allocate capital where
money market instruments offer value relative to their base-case interest rate scenario. This focus on value enables us to manage reinvestment
risk even when there is volatility in the market.
Counterparty risk
Counterparty risk is the risk that the counterparty or issuer of the debt will fail to fulfil its obligation to pay back the borrowed amount. This risk
was highlighted particularly by the Lehman Brothers bankruptcy in September of 2008 which resulted in money market funds having to write off
Lehman commercial paper. This lead to all commercial paper selling off indiscriminately, irrespective of the issuer, Banks stopped lending to each
other, cash markets froze and multiple counterparties, previously dependent on short-term funding, defaulted.
To manage counterparty risk, we only invest in counterparties with strong balance sheets – and analyse their prudential liquidity requirements,
as required by the Reserve Bank, to identify banks that are facing potential liquidity pressure. Even though poor quality counterparties generally
pay higher yields, we generally avoid them. Our goal is to generate steady interest income at low risk rather than the highest possible income.
Instrument risk
Instrument risk arises when the instrument does not perform as promised, due to adverse events in the market such as counterparty defaults or
an increase in underlying credit risk. Money market instruments comprise a variety of instruments, including plain fixed deposits, tradable certificates of deposit, treasury bills, asset-backed securities and commercial paper. These instruments have different risk characteristics, depending on
the issuer and term. Treasury bills and bank deposits have the least risk due to security in the capital structure and the quality of the issuer. On
the other hand, as demonstrated in the global financial crisis, commercial paper borrowers and asset-backed issuers have been known to fail.
When selecting money market instruments, it is important for managers to balance yield and risk and to know the nature of the underlying instruments. Managers could be lured into investing in high-yielding unsecured instruments where the yield does not compensate for the risk. We
manage instrument risk by investing in high quality instruments like bank deposits, which offer capital safety albeit at slightly lower yields, and
avoiding instruments that offer limited security such as poor quality commercial paper or asset-backed securities.
Liquidity risk
Liquidity risk arises when a money market fund experiences unexpected large cash outflows and has insufficient liquid assets to fund the
outflows. An example of this was during the financial crisis when asset-backed securities and commercial paper were sold at a discount to face
value as panicked investors redeemed en masse from money market and cash funds. Selling illiquid instruments such as fixed deposits before
maturity usually results in an additional cost, which reduces a fund’s income.
We manage liquidity risk by maintaining 5% exposure in overnight deposits. Additionally, instruments like step-up deposits (in which the fund is
significantly invested) are also relatively more tradable than fixed deposits or asset-backed securities, and provide an opportunity for the fund to
realize additional liquidity at no cost when cash is needed.
Although the money market asset class generally preserves capital in comparison to equities and bonds, we feel it is important that investors are
mindful of the potential risks associated with reaching for the highest yields. At RE:CM, our priority is to preserve capital, offer liquidity and
then generate yield at the lowest risk possible. It is not our objective to generate high yields by investing in risky counterparties and dubious
instruments.
Currently, the RE:CM Money Market Fund is one of the highest yielding funds available to South African investors on a net of fees basis. The fund
returned 5.7% over the last year while the sector average returned 5.5%. The high yield is not a result of investments in risky instruments but can
instead be attributed to having the lowest fees in the industry. The RE:CM Money Market Fund is managed extremely conservatively, only allocating funds to the highest quality money market instruments. Of course, this means that we willingly accept lower yields. We compensate for
this by charging a fee of only 15 basis points annually, the lowest in the industry. As a result, our fund has the highest net yield to retail investors
in the industry. Truly a case of having your cake and eating it!