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The Instruments Purchased by a Money Market Fund Money Market Funds invest in high quality short-term debt instruments. Although the restrictions imposed upon the funds do not tend to dictate the exact types of instruments which may be purchased, the broader investment universe for all money market funds is reasonably similar. An investor should understand the types of instruments which may be purchased by a money market fund, and also appreciate how risks can vary depending on the fund’s specific composition. This article examines the key instruments in more detail.

The Instruments Purchased by a Money Market Fund

by The Institutional Money Market Funds Association

Money market funds invest in high quality short-term debt instruments. Although the restrictions imposed upon the funds do not tend to dictate the exact types of instruments which may be purchased, the broader investment universe for all money market funds is reasonably similar. An investor should understand the types of instruments which may be purchased by a money market fund, and also appreciate how risks can vary depending on the fund’s specific composition.

Let’s look at the key instruments in more detail, starting with the simpler ones:

Deposits
A savings account held with a bank, which may be overnight or for a longer, and fixed, term. Fixed-term deposits can have a penalty applied if the investment is redeemed before the expiry of the term. This penalty is generally taken out through loss of interest paid to the investor.

Overnight deposits provide money market funds with natural liquidity. Each day, the fund has access to the cash held in the previous day’s deposits and can use this to meet any redemption requests. Cash remaining can be invested over a longer term, or may simply be rolled into another overnight deposit.

Issued by banks, a certificate of deposit is like a deposit but has a set maturity date and a pre-determined, fixed interest rate.

Money market funds have increased the amount of deposits held over the past few years as they seek higher levels of natural liquidity. This reduces the need for funds to sell any instrument in the secondary markets to meet investor redemptions.

Call accounts
A bank deposit where the investor can call, or withdraw his funds, at any time. The investment is open-ended, typically paying higher interest than standard deposits, but may require a short notice period before the funds are returned to the investor.

Government debt
A bond issued by a national government, which typically pays a fixed rate on a periodic basis until maturity. The risk associated with the bond is the risk of default of the government. For example, gilts issued by the UK government hold a AAA rating. These investments can therefore be very low risk, but as a result have a lower yield than instruments with a weaker credit rating.

Instruments guaranteed by governments or other supranational organisations may also be purchased by money market funds. These would include the US government-sponsored agencies of Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac).

Certificates of deposits (CD)
Issued by banks, a certificate of deposit is like a deposit but has a set maturity date and a pre-determined, fixed interest rate. CDs are actively traded on the secondary markets, where buyers may obtain a more competitive yield than that currently available on similar term deposits. This negotiability and active secondary market makes them more liquid than other forms of deposit.

Repurchase agreements (repo)
An agreement to sell and buy-back (or repurchase) a security after a certain time and at a specified price. The duration could be overnight, fixed or for an open term, but many are typically for a week at most. The underlying security provides collateral for a cash loan, and whilst many securities may collateralise a repo transaction, most are conducted with highly liquid securities such as Treasury Bills.

Money market funds may invest in other money market funds, but the latter should only be funds that are managed to the same standards as the investing fund.

Money market funds generally conduct reverse repo transactions, i.e., they act as the buyer of the collateral rather than the seller.

Commercial paper (CP)
A short-term note issued by banks and corporates to fund short-term credit needs, such as payroll obligations. It has a fixed maturity, typically less than 270 days.

The note is not backed by any collateral, and the secondary market for CP is limited, making only issuance by high quality banks and corporates attractive to investors. See also Asset backed commercial paper below.

Money market funds
Money market funds may invest in other money market funds, but the latter should only be funds that are managed to the same standards as the investing fund. This further diversifies the portfolio of the investing fund, but the amount that may be invested in other money market funds is generally limited to less than 10% of net assets of the investing fund.

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