Money market fund

Money market funds are registered investment companies that seek to maintain a stable  net asset value of $1.00 per share. They are heavily regulated by the Securities and Exchange Commission (Commission) under Rule 2a-7 of the Investment Company Act of 1940. Rule 2a-7 imposes strict diversification, credit quality and maturity standards on money market funds. Money market funds are viewed as conservative investment vehicles and historically have been viewed as being as safe as cash.

Money market funds are a critical source of short-term financing in the United States. Just prior to the events of the week beginning September 15, 2008, money market assets represented $3.5 trillion and had experienced only a single incident of “breaking the buck.” Additionally, market participants have come to expect advisers or sponsors of money market funds to support those funds.

The events of September 2008 resulted in a registered money market fund “breaking the buck” for only the second time in the history of money market funds, which precipitated a run on money market funds and “freezing” of the money markets. Another large fund closed its doors and liquidated, and many fund sponsors sought relief to provide various types of support agreements to funds.

As government and industry groups continue to assess what happened, it is clear that one of the consequences of the recent financial crisis will be greater scrutiny and heightened regulation of money markets funds. Based on industry proposals and developments to date, including the recent Report of the Money Market Working Group of the Investment Company Institute, it appears that regulatory developments and best practices will likely include greater reporting requirements for money market funds, an emphasis on transparency of portfolio holdings, and potentially “know your client” obligations.

Adoption of any or all of these requirements will require money market funds and their service providers to assess their systems for gathering, analyzing and reporting portfolio information and shareholder information.

SEC Enhancements to Rule 2a-7

The SEC published regulations for money market funds in 1983 to define and standardize the asset class. The regulations are known as Rule 2a-7 and were enhanced in May 2010. Those changes can be summarized as follows:

Credit Quality

• Reduced exposure limit for second-tier securities.
• Funds not permitted to acquire second-tier securities with remaining maturities of > 45 days.

Diversification

• More restrictive single-issuer limits.
• More restrictive collateral requirements for repurchase agreements qualifying for “look-through” treatment.

Liquidity

• Reduced exposure limit for illiquid securities
• At least 10% of total assets in Daily Liquid Assets (not applicable to tax-exempt funds).
• At least 30% of total assets in Weekly Liquid Assets.

Maturity

• Reduced Weighted Average Maturity (WAM) limit.
• Weighted Average Life (WAL) calculated without reference to any provision that would permit a fund to shorten the maturity of an adjustable-rate security by reference to its interest rate reset dates.

Portfolio Stress Testing

• Performance of stress testing (simulated shocks such as interest rate changes, higher redemptions, changes in credit quality of fund) as required by new policies and procedures adopted by the fund Board.

Transparency

• Monthly disclosure of all portfolio holdings on the fund’s website.
• Monthly filings of portfolio holdings and additional information (“shadow” NAV) with SEC.

Additional Board Powers

• Fund Board permitted to suspend redemptions and postpone payment of redemption proceeds if a fund will “break the buck” and if the fund will irrevocably liquidate.

Money market mutual funds have become an essential cash management tool for both institutions and individuals. They were created in the 1970s for investors disappointed with the yields available on bank savings accounts, which at the time were limited by federal regulation. Through money market funds, those investors could pool their funds together to buy higher-yielding short-term alternatives that were then generally available only in very large denominations. Money market funds quickly became a staple investment for both individuals and businesses. By the end of 2009, their assets topped $3 trillion, equal to roughly 30 percent of total fund industry assets.

While the benefits of owning a money fund have always been clear, the risks have been less so. Investors don’t expect to take a loss on shares of a money market fund. They anticipate instead that every dollar put into the fund will be returned, plus interest. That’s a reasonable expectation, because money market funds are designed to maintain a NAV of $1.00 per share. While the NAV of other types of mutual funds fluctuate daily, the NAV of money funds stays steady.

As investors learned to their shock in the 2008 credit crisis, the NAV of money market funds can indeed fall below $1.00—meaning that investors do bear a risk of loss, however small.

$1.00 NAV

At the end of each business day, money market funds, like all other mutual funds, must calculate and publish a NAV that equals the aggregate value of all of their holdings minus any liabilities. For all funds other than money funds, this NAV reflects the market value of the securities held in the fund. But money market funds are different. If they meet certain tests, as set out in the SEC’s Rule 2a-7, they can use the amortized cost accounting method to compute their reported NAV.2 This method allows them to reflect the price paid for the security—rather than its current market value—in the NAV calculation. No other mutual funds use this method.

Why is this treatment fair? Why don’t money funds have to report a market value NAV? Because the securities inmoney market funds are of very high quality and have only a very short time tomaturity. As a result, the odds are very high that investors will get their money back when the securities come due and that their values won’t vary much between now and then.

That means that the movements in the fund’s NAV will be small—usually less than $0.005 or one-half cent per share. In fact, these fluctuations are immaterial enough that it’s reasonable for the fund to keep the NAV at $1.00, a valuable convenience for investors. But that’s true only if the fund sticks to high quality short-term investments.

Here’s where Rule 2a-7 comes in. It keeps money market funds on the straight and narrow, by setting out detailed rules for money market portfolios—all designed to keep the NAV variation minimal. But it’s important to note that it’s not just Rule 2a-7 that keeps money fund management very conservative. Fund sponsors also want to make sure that they meet shareholders’ expectations—and they definitely don’t want to be called upon to provide financial support to their money funds, which could be the case if the NAV drops significantly. (We explain in a moment when that is likely to happen.)

Rule 2a-7 contains requirements for money funds in four areas: maturity, credit quality, diversification, and liquidity.

• Maturity

The longest maturity of the securities held by money funds is limited to approximately one year. (Technically, the limit is 397 days, based on themarket practice of issuing one-year securities with an initial maturity that is slightly longer than a year.) That may not seem like a long time, but one-year maturity instruments can experience a big swing in price with a large shift in the level of interest rates. If a money market fund put all of its assets into one-year securities, its NAV would be volatile—which is why 2a-7 also places a limit on the average maturity of the fund. Specifically, the weighted average maturity of all the securities held by a money fund may not exceed 60 days. If a fund holds longer maturity investments, they must be balanced with shorter maturities.

• Credit quality

Credit quality is of paramount importance to a money market fund since the default of a security can be catastrophic, as we’ll see. Rule 2a-7 states that money market investments must be of high quality, representing minimal credit risk. As of June 2010, it defines these as securities receiving ratings from the major credit rating agencies that place them in one of the top two short-term categories, or tiers. At least 97 percent of the fund’s assets must be invested in securities in the top tier, the one that theoretically carries the least credit risk; the other 3 percent of assets may be invested in money market securities in the second tier.

Table shows the three highest ratings tiers for short-term taxable securities for the major credit rating agencies.

The SEC is under pressure to establish quality standards for money market funds that do not refer to credit agency ratings. This should not result in a  significant change for most management companies, however, since Rule 2a-7 already requires that fund managers carry out independent credit analysis to verify that a proposed investment poses minimal
credit risk. Under 2a-7, managers have never been able to rely solely on the opinion of third parties when judging credit quality.

• Diversification

Rule 2a-7 also places restrictions on a fund’s exposure to the securities of nongovernment issuers. Specifically, money funds may not invest more than 5 percent of their assets in issuers in the top tier. If the issuer is rated in the second-highest category, the limit drops to 0.5 percent of assets per issuer. While Rule 2a-7 provides an upper bound, most  management companies actually have tighter internal guidelines.

• Liquidity

Money funds must be prepared to meet all shareholder redemptions without selling securities at a loss. (If a fund frequently locks in losses through sales, it violates the crucial operating assumption that it will usually get back what it paid for the securities it owns.) To make sure that money market funds will always have enough cash on hand, Rule 2a-7 requires that at least 10 percent of assets be liquid instruments with daily availability and that at least 30 percent of the fund be held in liquid instruments with weekly availability

At the other end of the liquidity spectrum, Rule 2a-7 requires that no more than 5 percent of the fund be invested in illiquid securities, meaning securities that may take more than a week to sell at close to the current price. This 5 percent limit is much lower than the 15 percent limit applied to illiquid securities held in stock and bond funds.

Taxable money market funds invest in the following types of securities:

• Treasury securities. The U.S. Treasury has become the largest issuer of money market securities. It uses the proceeds from their sale to fund the U.S. budget deficit and to meet short-term imbalances between cash receipts and disbursements. While the U.S. Treasury securities have maturities out to 30 years, those attractive to money market funds are known as Treasury bills. T-bills are normally issued with maturities of 13, 26, and 52 weeks. They do not pay interest through coupon payments; instead T-bills are zero coupon securities that are sold at a discount to par value and reach par at maturity. Because they are backed by the full faith and credit of the U.S. government, most investors consider T-bills to be credit risk-free. Their value will still fluctuate with interest rates, however. For example, a 52-week T-bill will rise and fall approximately 1 percent with a 1 percent change in interest rates. (Note that maturity and duration are roughly equal for short-term securities.)

• Agency securities. Agency securities are the obligations of federal government agencies or government-sponsored enterprises. Generally, agency debt offers a slight yield premium over T-bills.

• Commercial paper. Commercial paper, or CP, is issued by corporations (including banks) to finance short-term cash needs. While smaller corporations usually depend on bank loans for this type of funding, larger corporations with good credit ratings can access the CP market and often do so. By raising money from investors directly rather than from a bank, these companies can lower their borrowing costs. CP is normally issued with maturities of 270 days or less, though most CP has maturities of 90 days or under. Yields vary with maturity and credit quality, but CP normally offers a higher yield than Treasuries or agencies. Because CP has such a short maturity, the companies that issue it are almost constantly raising money in the market, rolling over or replacing CP that has just matured, as part of a commercial paper program. Since the CP market is generally open only to issuers with strong credit ratings, there have been few defaults over the years—but there have been some. As a result, credit analysis is important in this area, to identify problems early. “And the Little One Said, ‘RollOver’ ” describes a recent problem in the CP market.

• Certificates of deposit. Money market funds also make deposits in banks through  certificates of deposit. A CD, as the name implies, is a certificate that identifies a deposit with a specific banking institution, stating a maturity date and an interest rate. Certificates with banking institutions outside the United States—but still denominated in U.S. dollars—are known as Eurodollar CDs, or just Eurodollar deposits. CDs carry the federal deposit insurance provided by the FDIC, but because that insurance is capped at $250,000, it’s of little value to a large money market fund.6 As a result, good credit analysis of the bank issuing the CD is critical to avoid defaults.

• Repurchase agreements. Repurchase agreements, or repos, enable broker-dealers to finance the huge blocks of securities that they hold as part of their business. These securities are used as collateral for a repo loan.

Holdings in Tax-Exempt Funds

The tax-exempt money market is more complex than the taxable money market. That’s largely because of a supply-and-demand imbalance for very short-term municipal securities. There’s a high level of demand for these issues—much of it coming from individuals who want to minimize their tax bill by placing their cash in a tax-exempt money market mutual fund. But supply is limited. States and municipalities generally prefer to issue longerterm securities, since the money raised is normally used to support longlived projects such as roads or buildings or ongoing obligations, including the salaries of public employees. To provide a bridge between lenders and borrowers, a large derivatives market that synthetically creates short–term tax–exempt investments has evolved.

Tax-exempt money market funds invest primarily in the following securities:

• Municipal notes. Municipal notes are issued by state and local governments with a maturity of one year or less. In some cases, these notes finance a specific project, while others are used to provide short–term cash flow, anticipating the receipt of revenues of some type. For example, a local government that needs money to pay for road construction now but also needs more time to prepare for a bond offering may issue a Bond Anticipation Note. When the bonds are eventually issued, the proceeds are used to pay off the BAN. Similarly, TANs, or Tax Anticipation Notes, provide shortterm cash while a local government is waiting for tax revenues to come in. And RANs—the R is for Revenue—are issued when income from a specific project, such as a sewer facility, is expected in the future. In all of these cases, when the revenues clear, the notes are repaid.

• Commercial paper. As in the taxable market, maturities of tax-exempt commercial paper are generally shorter than 270 days—most often 90 days or shorter. In the municipal market, however, CP programs are often backed by a letter of credit from a highly rated bank or insurance company, which guarantees repayment in the event of the default of the issuer. That makes CP more attractive to money market funds, all of which are seeking minimal credit risk.

• Variable rate demand notes. Variable rate demand notes, or VRDNs— also known as variable rate demand obligations, or tender option bonds— represent the vast majority of securities used in tax-exempt money funds. A VRDN has two components:

1. A long-term tax-exempt bond, whichmay be guaranteed by credit insurance or a letter of credit from a bank.8 While this is a long-term bond, it pays interest at the rate of a short-term security (which is almost always lower than the rate on a longer-term bond).
2. A short-term put option, or demand feature, that allows it to be sold back to the issuer at face value whenever needed. This put is backed by a bank or other financial institution.