Money market funds, known for their low risk, low transaction costs and returns that are typically better than regular savings accounts, along with the flexibility to buy and sell at any time without the long-term commitment required for fixed deposits, are a popular tool for parking inactive funds.
However, are money market funds guaranteed to preserve capital? Under what circumstances could they suffer losses?
In theory, money market funds are capital conservatives, but there are always exceptions in the financial market.
1. Why do money market funds cause losses?
A money market fund (MMF) invests investor funds in a variety of highly liquid and high-quality short-term bonds, earning near-risk short-term interest. The returns offered by money market funds are generally close to those of fixed bank deposits.
At the international level, discussions on money market funds mainly focus on money market funds in US dollars, although several currencies also have their respective money market funds.The following discussion on money market fund losses mainly refers to the most important money market funds in US dollars.
Money market funds are generally considered a safe place to store inactive or short-term funds, characterized by low risk and low returns, low transaction costs, strong liquidity and high stability.
The biggest difference between money market funds and bank fixed deposits is that money market funds are not protected by bank deposit insurance (like the FDIC in the United States, which guarantees up to $250,000 per bank account). This means that while bank fixed deposits are protected up to a certain amount, money market funds may suffer losses.
The investment objective of money market funds is to pursue security and stability, aiming to never suffer losses.
Taking as an example the major money market funds in US dollars, these funds aim to keep their net asset value (NAV) at $1.
If the NAV of a money market fund drops below $1, it means that investors will not get $1 for every $1 invested, incurring losses.
A major global incident occurred in 2008 with the bankruptcy of Lehman Brothers, when the NAV of the Primary Reserve Fund fell to $0.97, equivalent to a loss of 3%.
2. Under what circumstances can money market funds cause a loss of capital?
Money market funds invest investors’ money in “highly liquid and secure short-term banknotes”, in simple words, these are investment targets that mature within a year, are extremely safe, can be easily liquidated and generate interest. These include banker acceptances, deposit certificates, commercial documents, repurchase agreements and short-term government debt issues.
From these instruments, it is clear that although these short-term banknotes are extremely secure, they are not 100% secure. For example, commercial documents still carry a default risk.
However, money market funds do not only invest in commercial documents. Investments in commercial documents are also diversified in many companies. Therefore, a default in a company’s trading securities would not have a drastic impact and the net value of the investment would not fall from 1 to 0. The most serious case in the history of US dollar money market funds was a drop from 1 to about 0.97, a loss of about 3%. In such extreme situations, where these safe investment instruments are highly regarded, governments usually intervene immediately to prevent the collapse of the entire financial system.
Generally, money market funds may suffer losses in situations such as:
The short-term documents they purchase by default.
Sudden and significant increases in interest rates caused bond prices to collapse.
Large-scale repayments by investors due to panic, force the sale of bonds at lower prices before maturity.
Notes:
Defaults on short-term documents are rare, but not impossible. These commercial documents usually constitute a very diverse small portion of money market funds.
In the event of a significant rise in interest rates, although it can cause a substantial fall in bond prices, short-term bonds have very short durations, which typically range from a few days to a few weeks, and are almost indifferent to interest rate risks. Even if there is a temporary impact on prices, capital can still be recovered at maturity after a few days or weeks. Therefore, temporary price fluctuations do not significantly affect their value.
However, it is essential to remember that money market funds are still funds. If repayments occur, fund managers must sell their positions. While short-term bonds are highly liquid, there may be times when liquidity is exceptionally low. If investors redeem in large numbers during these periods, even if the market may recover later, fund managers have no choice but to sell and stop losses.
3. The security of money market funds
Money market funds are considered highly secure due to the following characteristics:
Feature 1: Short-term investments, low interest rate risk
Money market funds invest in instruments that expire within one year, with a weighted average portfolio maturity of 90 days or less. The extremely short duration allows fund managers to adapt quickly to the ever-changing interest rate environment, thereby reducing interest rate risk.
Feature 2: High credit rating debt investments, low default risk
Money market funds invest only in the highest credit rating debt, usually AAA rated. These tools have a low risk of default.
Feature 3: Diversified investment objectives, risk reduction
In addition to government issued securities, money market funds may not invest more than 5% of their funds in a single issuing institution.
This diversification means that if a single investment target undergoes a credit rating downgrade, the impact on the entire fund will be within 5%.
Feature 4: linked to the reputation of the underlying companies
Since the participants in the money market funds market are large professional institutions, if the money market funds of these companies were to suffer losses, they would seriously damage their reputation. Historically, losses in such funds have been extremely rare. Therefore, companies that issue money market funds strive to avoid losses, improving investor safety.
Feature 5: Impact on stability of financial markets
Since money market funds are considered very safe, if they suffer losses, they would probably lead to mass ransoms, similar to a bank run, with unimaginable consequences.
Therefore, based on past experience, if money market funds suffer losses, peers or governments are likely to intervene, which further increases people’s expectations of the security of money market funds.
4. Money market funds crisis: a summary
Money market funds were born in 1970, and in over 50 years since then, there have been only two cases where the net asset value (NAV) of a fund has fallen below $1.
Crisis 1: 1994, small regional monetary fund falls below $1
Whenever a money fund faces problems, its issuing institution usually makes every effort to save it to maintain the company’s reputation, which is why money fund losses are rare.
The first loss recorded in history occurred in 1994, when the share price of a small regional monetary fund fell below $1. However, due to its small size, it was quickly saved without causing significant impact.
Crisis 2: 2008, Lehman Brothers bankruptcy lowers primary reserve fund below $1
Reserve, a New York-based money market fund specialist, had $64.8 billion in assets in its Reserve Primary Fund in 2008.
At present, the fund held $785 million in commercial securities issued by Lehman Brothers, constituting only about 1.21% of the fund’s total assets.
In 2008, during the financial crisis, Lehman Brothers declared bankruptcy on September 15, rendering the commercial securities held by the Primary Reserve Fund useless. This caused the NAV of the fund to fall to 97 cents, which means that an investment of $1 could only recover 97 cents.
Worse still, due to investors’ concerns about the fund’s losses, almost two thirds of the fund were redeemed within 24 hours.
Failing to meet these repayment requests, the fund froze repayments for up to seven days and was forced to suspend operations and begin liquidation.
The collapse of the money fund has had a significant impact on the whole market. Even those money market funds not affected by Lehman Brothers faced huge repayments due to investor panic.
As a result, more than a dozen fund companies were forced to intervene, providing financial support to money market funds to prevent them from falling below the $1 threshold.
In the end, the US government intervened.
The US Treasury Department offered a temporary guarantee program for money market funds, assuring investors that the value of each share held in money market funds at the close of September 19, 2008 would be maintained at $1 per share.
This incident also created an expectation: if money market funds were to experience such a disaster again, the government would intervene to save them.
5. Risks of investing in money market funds
The risks associated with investing in money market funds include:
Sudden significant changes in interest rates, credit rating downgrades of multiple companies and corporate insolvencies.
Mass refunds in the market due to panic.
Market interest rates (such as the Federal Funds Rate) fall below the fund’s spending ratio, potentially causing losses.
Generally, US dollar money market funds are considered risk-free, as their security is similar to government bonds and bank fixed deposits. If they incur significant losses, it would be a serious problem such as a default on US government bonds or a reduction in bank fixed deposits. We can’t say that these risks are impossible, but the likelihood of them happening is really very low, usually only in extremely unusual circumstances.
Of course, money market funds in currencies other than the US dollar may not be as secure, which is similar to the fact that government bonds from countries other than the US may not have such a high credit rating.
6. Considerations before investing in money market funds
6.1 Examine the assets held by the fund. If you are not clear on what you are investing, it is better not to invest.
6.2 Look for funds with lower spending rates. Lower costs can generate higher potential returns without adding additional risks.
6.3 Prefer larger companies. Compared to smaller companies, larger companies typically have more abundant funds and are better able to withstand short-term fluctuations. Therefore, since everything else is the same, the bigger the company, the better.
6.4 Diversifying the portfolio. Distributing money between different asset classes can prevent personal financial difficulties due to problems with a particular asset.
Although it is generally believed that the probability of losses in money market funds is minimal, money market funds are not limited to the US dollar alone; There are also funds in various other currencies. Not all government bonds are as secure as those of the United States, so it is still necessary to assess against the specific investment target chosen.
