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 of buying and selling at any time without the long-term commitment required for fixed deposits, are a popular tool for parking idle funds.
However, are money market funds guaranteed to preserve capital? Under what circumstances might they incur losses?
In theory, money market funds are capital-preserving, but there are always exceptions in the financial market.
1. Why Do Money Market Funds Incur Losses?
A Money Market Fund (MMF) invests investors’ funds in a variety of high-quality, highly liquid short-term bonds, earning almost risk-free short-term interest. The returns offered by money market funds are generally close to those of bank fixed deposits.
Internationally, discussions about money market funds mainly focus on U.S. dollar money market funds, although different currencies also have their respective money market funds. The following discussion about the losses of money market funds primarily refers to the most important U.S. dollar money market funds.
Money market funds are generally considered a safe place to store idle 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 (such as the FDIC in the United States, which guarantees up to $250,000 per account per bank). This means that while bank fixed deposits are protected up to a certain amount, money market funds may incur losses.
The investment objective of money market funds is to pursue safety and stability, aiming never to incur losses.
Taking the most mainstream U.S. dollar money market funds in the United States as an example, these funds aim to maintain their net asset value (NAV) at $1.
If the NAV of a money market fund falls below $1, it means that investors will not get back $1 for every $1 invested, incurring losses.
A significant global incident occurred in 2008 with the bankruptcy of Lehman Brothers, when the Reserve Primary Fund’s NAV fell to $0.97, equivalent to a loss of 3%.
2. Under What Circumstances Can Money Market Funds Incur a Loss of Principal?
Money market funds invest investors’ money in “highly liquid and safe short-term notes,” simply put, these are investment targets that mature within a year, are extremely safe, can be easily liquidated, and generate interest. These include Bankers’ Acceptances, Certificates of Deposits, Commercial Papers, Repurchase Agreements, and Short-term Government Debt Issues.
From these instruments, it is evident that although these short-term notes are extremely safe, they are not 100% secure. For instance, commercial papers still carry a default risk.
However, money market funds do not invest solely in commercial papers. The investment in commercial papers is also diversified across many companies. Therefore, a default in the commercial papers of one company would not have a drastic impact, and the net investment value would not plummet from 1 to 0. The most severe case in the history of U.S. dollar money market funds was a drop from 1 to about 0.97, a loss of approximately 3%. In such extreme situations, where these highly regarded safe investment tools are affected, governments usually intervene immediately to prevent a collapse of the entire financial system.
Generally, money market funds may incur losses in situations such as:
The short-term papers they purchase default.
Sudden and significant increases in interest rates, caused bond prices to plummet.
Large-scale redemptions by investors due to panic, force the sale of bonds at lower prices before maturity.
Notes:
Defaults on short-term papers are rare, but not impossible. These commercial papers usually constitute a small, well-diversified portion of money market funds.
In the event of a significant rise in interest rates, though it could cause a substantial drop in bond prices, short-term bonds have very short durations, typically ranging from a few days to a few weeks, and are almost unaffected by interest rate risks. Even if there is a temporary price impact, the principal can still be recovered upon maturity after a few days or weeks. Hence, temporary price fluctuations do not affect their value significantly.
However, it’s essential to remember that money market funds are still funds. If redemptions occur, the fund managers need to sell their positions. While short-term bonds and notes are highly liquid, there might be times when liquidity is exceptionally low. If investors redeem in large numbers during such times, even if the market might recover later, the fund managers have no choice but to sell and stop losses.
3. The Safety of Money Market Funds
Money market funds are considered highly safe due to the following characteristics:
Characteristic 1: Short-Term Investments, Low-Interest Rate Risk
Money market funds invest in instruments that mature within a year, with a weighted average portfolio duration of 90 days or shorter. The extremely short duration allows fund managers to quickly adjust to the ever-changing interest rate environment, thereby reducing interest rate risk.
Characteristic 2: Investments in High Credit Rating Debt, Low Default Risk
Money market funds invest only in the highest credit rating debt, usually AAA-rated. These instruments have a low risk of default.
Characteristic 3: Diversified Investment Targets, Reduced Risk
Besides government-issued securities, money market funds cannot invest more than 5% of their funds in any single issuing institution.
This diversification means that if a single investment target experiences a credit rating downgrade, the impact on the entire fund will be within 5%.
Characteristic 4: Tied to the Reputation of Fund Companies
As the participants in the money market fund market are large, professional institutions, if these companies’ money market funds incur losses, it would severely damage their reputation. Historically, losses in such funds have been extremely rare. Therefore, companies issuing money market funds strive to avoid losses, enhancing investor safety.
Characteristic 5: Impact on Financial Market Stability
Since money market funds are considered very safe, if they incur losses, it would likely lead to mass redemptions, similar to a bank run, with unimaginable consequences.
Therefore, based on past experiences, if money market funds suffer losses, peers or governments are likely to intervene, which further enhances people’s expectations of the safety of money market funds.
4. Crises in Money Market Funds: A Summary
Money market funds originated in 1970, and in the more than 50 years since then, there have only been two instances where the net asset value (NAV) of a fund fell below $1.
Crisis 1: 1994, Small Regional Money Fund Falls Below $1
Whenever a money fund faces issues, its issuing institution usually makes every effort to rescue it to maintain the company’s reputation, which is why losses in money funds are rare.
The first recorded loss in history occurred in 1994 when a small regional money fund’s share price fell below $1. However, due to its small size, it was quickly rescued without causing a significant impact.
Crisis 2: 2008, Lehman Brothers’ Bankruptcy Causes Reserve Primary Fund to Drop Below $1
Reserve, a company specializing in money market funds based in New York, had $64.8 billion in assets in its Reserve Primary Fund in 2008.
At that time, the fund held $785 million in commercial papers 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 15th, making the commercial papers held by the Reserve Primary Fund worthless overnight. This caused the fund’s NAV to fall to 97 cents, meaning an investment of $1 could only retrieve 97 cents.
Worse still, due to investor concerns about the fund’s losses, nearly two-thirds of the fund was redeemed within 24 hours.
Unable to meet these redemption requests, the fund froze redemptions for up to seven days and was forced to suspend operations and begin liquidation.
The collapse of the money market fund had a significant impact on the entire market. Even those money market funds not affected by Lehman Brothers faced massive redemptions due to investor panic.
Consequently, 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.
Eventually, the U.S. government stepped in.
The U.S. Treasury Department offered a temporary guarantee program for money market funds, assuring investors that the value of each share they held in money market funds as of the close on 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 step in to rescue them.
5. Risks of Investing in Money Market Funds
The risks involved in investing in money market funds include:
Sudden significant changes in interest rates, credit rating downgrades of multiple companies, and company defaults.
Mass redemptions in the market due to panic.
Market interest rates (such as the Federal Funds Rate) fall below the fund’s expense ratio, potentially causing losses.
Generally, U.S. dollar money market funds are considered risk-free, as their safety is akin to government bonds and bank fixed deposits. If they were to incur significant losses, it would be a problem as serious as a default on U.S. government bonds or a reduction in bank fixed deposits. We cannot say that these risks are impossible, but the probability of their occurrence is indeed very low, usually only in extremely unusual circumstances.
Of course, money market funds in currencies other than the U.S. dollar might not be as safe. This is similar to the fact that government bonds from countries other than the United States may not have as high a credit rating.
6. Considerations Before Investing in Money Market Funds
6.1 Review the assets held by the fund. If you are not clear about what you are investing in, it is best not to invest.
6.2 Look for funds with lower expense ratios. Lower expenses can yield higher potential returns without adding extra risk.
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, all else being equal, the larger the company, the better.
6.4 Diversify your portfolio. Spreading your money across different asset classes can prevent personal financial difficulties due to issues with one particular asset.
Although it is generally believed that the likelihood of losses in money market funds is minimal, money market funds are not limited to just the U.S. dollar; there are funds in various other currencies as well. Not every country’s government bonds are as safe as those of the United States, so it is still necessary to evaluate based on the specific investment target you choose.