Are Money Market Funds Still Safe?
The Securities and Exchange Commission (SEC) voted last week to impose new rules on money market funds aimed at preventing mass selling during financial panics. The most significant change was the elimination of the fixed $1 share price for certain types of funds. Mary Jo White, SEC Chairwoman, announced: “Today’s reforms fundamentally change the way that money market funds operate.” Do these changes make money market funds more risky? Is this a good time to bail out of them in favor of other types of investments?
First, a little background. A money market fund is a type of mutual fund that was developed in the 1970s as a way for investors to get higher returns than interest-bearing bank accounts by purchasing a pool of very short-term securities. What’s unique about money market funds is their ability – thanks to a provision in the 1940 Investment Company Act allowing such funds to value their investments at amortized cost rather than at market value – to maintain a constant $1 per share net asset value (NAV). This feature has made money market funds extremely popular, helping them collectively to grow to almost $3 trillion today.
However, there have been occasions when a money market fund was unable to maintain a $1 NAV. The first such fund to “break the buck,” as it’s known, was First Multifund for Daily Income (FMDI) in 1978. FMDI was technically not a money market fund because the managers violated their own strategy of investing in short–term (30-90 day) money market obligations when they started buying increasingly longer-maturity securities in order to try to drive up returns. Nonetheless, the fund was forced to restate its NAV to 94 cents when interest rates unexpectedly soared, costing its investors 6% on their holdings.
In 1994 The Community Bankers US Government Fund broke the buck, paying investors only 96 cents per share. In this case the fund utilized risky derivatives to try to generate higher returns, and, as with FMDI, got caught when interest rates rose. Because the fund’s depositors were mostly banks, no consumers were impacted (at least directly).
The only other failure in the then 37-year history of money funds occurred in 2008, when Reserve Primary, which had been heavily invested in Lehman Brothers’ debt, was forced to restate its NAV to 97 cents after Lehman went bankrupt. (One might be somewhat sympathetic to Reserve Primary when you consider that the Lehman debt had been rated as AAA quality just a few days before the bankruptcy.)
Primarily as a result of the Reserve Primary failure, the SEC has been working on a way to avoid this problem in the future. After five long years of discussion and debate, here are the new rules:
- Government money market funds – those including 99.5% or more of their total assets in cash, government securities, or repurchase agreements collateralized by government securities or cash – will be allowed to continue to maintain a stable $1 price per share.
- Prime institutional money market funds (those that invest in riskier commercial paper) will no longer be able to keep their NAV at $1 per share. Prices will now float with the current market values of their portfolio holdings. (There’s a further exemption that allows prime funds sold only to retail customers to maintain the $1 share price.)
- All money market funds will have the authority to suspend redemptions for up to ten days if fund liquidity drops below 30% and impose redemption fees of up to 2% if liquidity drops below 10%. (Although money market funds have always has similar restrictions in place, most investors have never been aware of them, nor have the funds ever been willing to impose them.)
The goal of these rule changes is to reduce shareholders’ incentive to make mass withdrawals by forcing money fund prices to more accurately reflect their actual values. The SEC vote on these new rules was close (3-2) and some members were concerned that such restrictions would actually have the opposite effect. Which brings us back to the original question: are money market funds still worthwhile investments?
Despite some pundits’ outcries to the contrary, I don’t see money market funds becoming any more or any less risky than they’ve always been. Although I don’t necessarily believe that these new rules are the best way to have addressed the problem (let alone whether or not they will have solved it), the biggest impact I believe they will have on the marketplace is:
- Prime institutional money market funds will most likely disappear in favor of ultra-short term bond funds. These are funds that provide a higher return than bank CDs with greater liquidity, but at a cost of some small degree of principal risk.
- Government money market funds will remain as an (almost) principal-risk free asset class providing relatively safe, money market returns.
- The general public will become more aware of the risk that money market funds have always carried. While this is a good thing, it could result in a reduction in money market fund purchases, which could put some stress on the industry.
It’s important to keep in mind that even banks are not 100% safe. The federal government set up the Federal Deposit Insurance Corporation (FDIC) to protect your deposits (within limits) in cases of bank failures. There are in fact money market funds offered by banks through some financial advisors that carry the FDIC guarantee. They add a further measure of safety for cash maintenance beyond ordinary money market funds. The safest place in the world to stash your cash remains U.S. treasury bills, but as with bank CDs, you give up some liquidity to do so. In the end, the decision as to where to invest cash for the short-term will continue to be a tradeoff between safety, liquidity, and returns.
One of the biggest remaining questions from the new rules is an accounting one. It is not yet clear how tax rules on capital gains and losses will apply to money market funds moving forward. In any case, fund companies will have up to two years to implement these changes, enough time for the IRS to weigh in.
As with most government regulations, the new rules are explained in a terse 869 page document. If you feel inclined to read it in detail, you can find it here: http://www.sec.gov/rules/final/2014/33-9616.pdf.