Money market funds’ (MMFs) portfolio composition and sensitivities have changed significantly since the 2008 financial crisis, which shook the industry and investors’ confidence in MMFs’ ability to deliver on their objectives of preserving principal and providing liquidity. Since then, money funds have had to adapt to fast changing market dynamics, persistently-low interest rates, imposed regulatory changes, heightened investor risk aversion, a growing European sovereign crisis and, more recently, uncertainties relating to the US debt ceiling. To date, MMFs have successfully navigated through these challenges, demonstrating that they are actively managed products, which is an essential benefit for investors, particularly in turbulent financial environments.
MMFs are key players in the short-term debt markets, accounting for approximately US$4.5 trillion of assets globally. Typically invested in short-term debt of high-credit quality issuers, they seek to limit credit, market and liquidity risks at all time, as reflected in their investment practices and guidelines. An analysis of MMFs over the past three years, with a particular focus on the universe of Fitch-rated MMFs, evidences the dramatic shifts that have been implemented in their portfolios.
Money fund portfolios show three key trends:
- A progressive reduction of exposures to peripheral European countries.
- A greater emphasis on maintaining a high proportion of liquid assets in funds’ portfolio.
- Conservative positioning along the yield curves.
Selective and Regularly-adjusted Eligible Lists
The credit process implemented by MMF managers includes regular reviews and adjustments to the exposure and tenor limits of the names they define as eligible investments to reflect market dynamics and their changing views on the risks associated with each issuer.
Fitch-rated MMFs actively manage and limit their exposures to higher quality, diversified portfolios. MMFs began adjusting their exposures to certain European issuers starting in 2009, as market volatility and concerns over some peripheral European countries started to affect the perceived credit risk of financial institutions in those countries. These country risk related adjustments have continued until now, while going through various observable phases as the centre of attention shifted. Among Fitch-rated MMFs, for example, the very small residual exposure to Greece that may have been left in early 2009, had been removed by the end of that same year. At the same time, investments in Irish financials had also been subject to more conservative tenors and exposure limits, with some funds removing all Irish exposure.
Through 2010 and 2011 year-to-date, fund managers took further actions on Portuguese, Spanish and Irish issuers, applying more conservative exposure limits, shorter tenors and more restricted lists of eligible names from these countries. Fitch has observed the following trends among its universe of rated funds, based on portfolio holdings provided to Fitch as part of its regular surveillance process on rated funds:
- The small exposure to Portuguese institutions that was left in some portfolios had been removed by 3Q10.
- Exposure to Irish names went through a second period of reduction in 2010. It was significantly lowered over summer 2010 and became contained to overnight cash or call accounts, before being simply removed from all portfolios by the end of that year.
- Exposure to Spanish names has been selectively adjusted as MMFs have gradually focused on those financial institutions viewed as systematically important and having stronger credit profile, namely Banco Santander and Banco Bilbao Vizcaya Argentaria (BBVA). Average maturities of these exposures have also been shortened.
- Similarly, exposure to Italian banks has been affected, with greater concentration in short-term instruments below three months and confined to Intesa SanPaolo and UniCredit.
At mid-2011, MMFs were maintaining high credit quality exposures to sovereign and financial institutions from the ‘core’ European countries of France, the UK and Germany. The largest exposures to individual institutions have nevertheless markedly evolved as detailed in Figure 1.
Figure 1: Average Country Exposure in Fitch AAA-rated European MMFs
Figure 2: Asset Mix Evolution- AAA-rated Offshore MMFs
Source: Fitch, MoneyNet
Figure 3: WAM Evolution – Offshore Prime MMF’s
Source: Fitch, MoneyNet
Active Liquidity Management an Essential Factor
Active liquidity management is another essential investment objective of MMFs, particularly as they seek to provide shareholders with daily liquidity. Portfolio managers must manage the fund’s portfolio of investments consistent with the expected liquidity requirements of the fund’s investors. Without careful liquidity management, a fund may be faced with difficulty meeting investors’ redemption requests, particularly during times of market stress. Stressed markets typically lead to secondary market activities drying up, making it difficult for MMF manager to sell assets at a reasonable price.
Sources of potential liquidity risk in MMFs can result from one or more of the following items:
- Unexpected redemption activity in excess of a fund’s available liquidity in overnight or readily marketable assets.
- Large investments from a concentrated shareholder base or shareholders exposed to the same market sectors that would tend to exhibit the same investment/disinvestment behaviour.
- Exposure to asset classes that may be exposed to sudden unexpected lack of liquidity.
MMFs typically invest in short-term debt such as commercial papers, asset backed commercial papers (ABCP), certificates of deposits, time deposits, repurchase agreements, and fixed and floating-rate bonds and notes issued by corporates, governments or government agencies. However, not all of these instrument types benefit from the same level of liquidity.
Floating rate notes rated A or below and ABCP, for example, are among the least liquid assets mentioned above. As a result, MMFs that have been looking for increased liquidity in their portfolios of assets since the second half of 2007 made a significant move into more liquid asset classes between 2007 and 2010, reducing their investments in ABCP and floating-rate notes, or even in some cases removing such assets. On average, ABCP accounted for more than 30% of assets in MMFs rated by Fitch in June 2007, falling to less than 11% at end-July 2011. Similarly, the proportion of MMFs’ assets invested in floating-rate notes has dropped to 7% on average at mid-2011, from 20% in 2007, prior to the financial crisis.
Conversely, investments in overnight or callable repurchase agreements have increased markedly due to their high liquidity, accounting for more than 20% of portfolios on average, compared with less than 10% four years ago.
At time of market uncertainty or investor nervousness, MMFs typically aim to increase their allocations to overnight, highly liquid assets. This was notably illustrated during the months following the collapse of Lehman, when MMFs maintained on average close to 40% in overnight liquidity. Liquidity fell somewhat as markets stabilised thereafter, but MMFs continue to be managed with a greater focus on liquidity risks than before the crisis. As such, portfolio managers remain flexible in order to adjust their liquidity positions as markets or investor behaviour change.
More recently, growing market nervousness around a potential US default led MMFs to bolster liquidity in the event of large redemption activity. MMFs increased their liquidity profiles in July through investments in daily and weekly liquid assets, such that US government MMFs were operating with close to 60% of their assets in repurchase agreements and assets maturing within one week by mid- to late-July. Likewise, US prime MMFs on average were holding approximately 32% of their portfolios in assets maturing in one week or less.
Managing Interest Rate Sensitivity
MMFs bear some interest rate risk, often measured via the portfolio’s weighted average maturity to interest
rate reset date, also referred to as WAM or WAMr. This interest rate risk is generally limited given that MMFs maintain low WAM levels, below 60 days as per the US and European regulatory regimes. In Europe, this applies to short-term MMFs only; funds in the broader European MMF category may have a WAM of up to six months.
Within this 60-day limit, MMFs manage their interest rate sensitivity in relation to their expectations of future interest rate movements. Provided they have the appropriate operational and control set-up, they may use interest rate swaps to actively adjust their portfolio’s interest rate sensitivity. This assumes that the fund is domiciled in jurisdictions that permit derivatives usage. Otherwise, on top of the portfolio manager’s view on interest rates the fund’s WAM may be affected by liquidity, primary issuance and maturity management considerations.
In stable rate environments with upward sloping yield curves, funds are typically looking to extend their maturities to benefit from the higher yields of longer dated assets. This was notably the case in 2009 with MMFs gradually extending their WAM. In 2010, however, the trend was less pronounced as MMFs maintained median WAM of between 30 to 40 days, despite market expectations of stable rates. This reflected the fact that portfolio managers deemed the risk return trade-off unattractive, with a rather flat yield curve, and chose instead to build portfolio liquidity as continued investor concerns on some European sovereigns weighed against more pronounced market risk exposures.
Conversely, when interest rates are rising or expected to rise, portfolio managers defensively position their funds with a shorter WAM so as to minimise interest rate risk. When the European Central Bank (ECB) surprised the market in early March 2011 by indicating it might raise its policy rate as early as April, those euro MMFs that can use interest rate swaps were able to quickly adjust their WAM. Other funds dynamically adjusted their WAM by reinvesting maturing securities in shorter maturity assets.
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