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Dissecting Risk in Money Market Funds

by Dallas Ebel, Director of Eastern U.S. and Latin America Institutional Distribution, BofA Global Capital Management and Michael Tafur, Managing Director, Global Liquidity Investment Solutions, Bank of America Merrill Lynch

Before selecting a fund, investors should evaluate the risk profiles of the money market funds they are considering.

Given treasury professionals’ sharp focus on principal stability, it only makes sense that money market funds have become a staple of corporates’ liquidity-management programmes. Professionally managed and highly diversified, money market funds historically have been among the most liquid and stable investments available. However, the strong track record of money funds should not lull investors into a false sense of security. Money market funds can be vulnerable to market disruptions – some more than others because portfolio risk varies from fund to fund. As such, treasury professionals need to carefully vet funds’ investment risk to ensure a fund manager’s risk appetite aligns with their risk tolerance.

When evaluating a money market fund’s ‘risk’, the investor must assess three types of risk – credit risk, liquidity/redemption risk and interest rate risk. The major drivers of performance and portfolio volatility, these risks can be difficult to analyse because they are increasingly interconnected. That said, it is vital to conduct at least a rudimentary analysis of these risks when screening funds. This is especially true in the current low-rate environment, which could encourage fund managers to take on additional risk to help boost yield.

Credit risk

In the fixed income space, credit risk refers to the probability of an issuer defaulting on principal or interest payments or of suffering a credit rating downgrade that would decrease the value of its outstanding debt. A money market fund’s credit risk is a function of the credit quality of its individual holdings. A fund with a heavy allocation to US Treasuries, US federal agency debt and AAA-rated corporate debt typically would be considered less risky than a fund with a smaller allocation to those securities and a larger exposure to credits with a higher risk of default or downgrade.