Liquidity in the Money Market Arena: Not All Funds are Created Equal!
The desire to build a better mousetrap is laudable; however, in the case of money market funds, some have forsaken the very concept of the product in a blind quest for, at best, a marginal increase in yield. The money market fund was created to serve as an attractive vehicle to manage cash with maximum stability and liquidity, while providing a competitive rate of return.
Given these circumstances, a corporate treasurer can find it a confusing and costly process to identify a money market fund that offers the desired combination of liquidity, safety and yield. There are, however, some very important factors that can make the search more manageable.
All U.S. money market funds must operate under Rule 2a-7 of the Investment Company Act of 1940. This rule was created to assure investors that they are investing in a money market fund, but it leaves plenty of room for interpretation. Characteristics of liquidity can differ not just between major classifications of money funds, but from fund manager to fund manager within a classification as well. Careful consideration of a fund’s Prospectus and Statement of Additional Information and a fund’s operating policy will help unmask some of the differences, and potential risks.
The classification of a money market fund, which is determined by its underlying securities, often dictates its liquidity potential.
Pure U.S. Treasury funds invest strictly in direct obligations of the Treasury (treasury bills, notes, bonds and treasury strips) and investments in repurchase agreements (repos) are prohibited, regardless of the collateral. These funds are considered the safest type of money market fund, since there is no counter-party risk and the risk associated with U.S. Treasury securities is minimal. However, the cutoff for a fund manager to purchase these securities is 3:00 P.M. (New York Time), as is the usual cutoff time for fund shareholder transactions. Both the securities and the funds themselves offer daily liquidity until this time, but treasurers who need later day liquidity are precluded from participating.
These funds are typically considered safe, but they do include the counter-party risk inherent in every repo transaction.
Repos are liquidity instruments used by most money market funds and, while technically a purchase coupled with a simultaneous resale, are considered a collateralized loan. The next logical questions become who is the borrower and what is the collateral? The spectrum of collateral runs from U.S. Treasury securities to high yield bonds and even equities. Disturbingly, the use of equities and high yield bonds as collateral has grown dramatically and represents as much as 5% of the assets in some nominal money funds. The premise behind repos is that in the event of a default by the counter-party, the underlying collateral would be liquidated to satisfy the loan. Obviously, as the quality of collateral has deteriorated, the inherent risks of repos have increased.
These funds can also carry some risk, even though their portfolios are limited to U.S. Treasurys, agencies and repurchase agreements. Here credit quality is considered to be safe, but there’s still concern over the exposure to repurchase agreements (the same issues regarding collateral deterioration, as discussed in previous paragraph). Recently, speculation has also surrounded the implied government guarantee for certain U.S. agencies (as well as the underlying accounting and management practices of these agencies).
Tax-exempt money market funds are in a world by themselves. Traditionally used by retail investors, they have recently become more popular for corporate treasurers due to their sometimes net after-tax premium. The tax-exempt market has a cutoff of 11:30 a.m. (New York Time) for same day settlements, so investors must plan ahead. Liquidity for portfolio securities depends on the size of the issue, diversification of investor base and the remarketing agent. Consequently, treasurers are limited to making either small investments or using only large funds and obviously must have the need for the U.S. tax exemption.
How liquid are all the securities held by a money market fund? Collateralized debt obligations, extendable notes, funding agreements, taxable municipal bonds, auction rate preferred and structured products with limited documentation and market penetration are potential problems. While many of these products are solid investments, understanding their inherent illiquidity is key to quantifying the associated risk.
Another popular investment option for money funds is commercial paper, which can confront the corporate treasurer with another set of problems. For example, smaller commercial paper issuers that lack a broad investor base may be difficult to sell for same day settlement. The events of September 11, 2001 also created real challenges for fund complexes with large exposure to commercial paper. Due to concerns over the accuracy of back office records specific to commercial paper, the broker/dealer community suspended trading in these securities for several days. As a result, virtually all money market funds that held commercial paper closed for several days following September 11th to avoid potential liquidity issues.
In many cases, the level of liquidity a fund offers isn’t as complex as the underlying securities of the money fund itself; but rather as simple as the cutoff time for purchases and redemptions. Over $1.4 trillion is still invested in money funds with a 4:00 p.m. (New York Time) cutoff, despite the existence of a number of significant funds that are open until 5:00 p.m.
A further restriction on liquidity occurs when a money fund opts for an early close when equity or bond markets close early (prior to long holiday weekend). Additionally, some funds close completely on days when the stock market is closed, despite both banks and the Federal Reserve remaining open (such as Good Friday). The Federal Reserve wire system is normally open until 6:00 p.m. (New York Time), so money market funds with a 5:00 p.m. close are able to comfortably place trades until 5:30 p.m. and settle by 6:00 p.m. Early cutoff, in many cases, equals no access.
It is imperative that corporate treasurers understand the inner workings of their money market funds. Do the funds truly provide liquidity, safety of principal and current income? Or are the funds actually a total return bond fund in disguise? Investing in a money fund cannot be a “set it and forget it’ proposition. When it comes to determining ultimate liquidity, treasurers must be intimately familiar with not only the classification of the money fund’s portfolio holdings, but also the diversity of its holdings and their ultimate liquidity, counter-party exposure, normal buy/sell cutoff times and the fund’s philosophy as to preference for long, leisurely weekends or customer liquidity.
The opinions expressed are those of Robert Fort as of the date of initial publication. This material does not constitute investment advice and is not intended as a recommendation of a specific investment.