Published: July 01, 2010
When investing cash, investors seek to preserve the security of their capital. One of the principal determinants of whether any investment is able to maintain capital value is the credit quality of that investment. With this in mind, and based upon recent experiences, investors in money market funds should now have a greater interest in credit risk and how this risk is managed.
Money market funds provide a viable means of outsourcing short-term cash management. One advantage of these funds is the dedicated resources employed by the fund manager, which will include credit analysts. The depth of these resources is often significantly greater than that which could be accessed by the investor, meaning that investors in these funds benefit from additional credit capabilities.
To understand how credit risk is managed, an investor can review the credit analysis process that is performed by the money market fund manager. Whilst the detail of any credit assessment will vary by fund manager, there are some generic aspects which are relatively consistent. An overview of these aspects is provided below, and further information on the specific process employed can always be obtained directly from any fund manager.
Credit assessment is one of the factors considered when selecting instruments for inclusion in a money market fund. Before providing an overview of the credit assessment process, let’s define what credit risk is.
Credit spread risk is a key risk to be managed in a money market fund. ‘Credit spread’ is the additional return earned above the ‘risk free rate of return’ and is a reflection of a bond issuer’s creditworthiness or its perceived ability to pay back principal and interest in a timely manner. For example, if we assume the rate that Germany as a sovereign can borrow money in the market is an example of a risk free rate, the additional premium that Volkswagen needs to pay investors to compensate them for the additional risk of investing in Volkswagen debt versus German sovereign debt is known as the credit spread. This spread will fluctuate depending on the market’s view of the relative creditworthiness of, in this example, Volkswagen and the German government.
As the spread moves, so too does the yield. If the credit spread widens (increases), there is a greater risk associated with the asset than with the risk-free rate. To further compensate investors for this increase in risk, the yield payable must also increase. Although obtaining a higher yield may be positive for investors in the bonds, existing bondholders will lose money. This happens because when yields increase, prices fall – an inverse relationship. The impact of a rise in yield on existing bondholders can be explained using an example of a 5-year maturity UK government bond (Gilt) originally offered to investors at a price of 100.00 and a coupon of 5%. For these purposes let’s assume that on the following day 5-year UK Gilt yields increase by 1% to 6%. The gilt in our example will now be less attractive to investors as the coupon paid (5%) is lower than the rate that is now available in the market. The price of the asset would have to fall below 100.00 to compensate investors for the lower coupon paid.
Money market fund managers must carefully manage credit spread risk in order to avoid having the fund’s investments lose value due to yield increases. One way in which this is achieved is to manage the duration of the assets in the fund. The longer the maturity of an asset, the higher the potential for movements in credit spreads to impact the value of that asset. For example, a Volkswagen bond with a duration of one year will be more sensitive to changes in credit spreads than a Volkswagen bond with a duration of six months. Managing the duration of the assets in the portfolio is then key to also managing credit spread risk. [[[PAGE]]]
Credit spread risk is often the greatest source of risk in a money market fund. The yield payable by the fund is often generated by purchasing assets which trade at discounted prices and offer attractive credit spreads. Assets with this yield profile are frequently floating rate instruments. As we have seen, the longer the duration, the greater the credit spread risk and potential price volatility. Minimising this price volatility, and hence managing credit spread risk, is very important in order to maintain a constant net asset value – due to the small variance in market and amortised values that is permitted. To manage this risk, limits are placed on the maturity of individual assets in the portfolio, and on the portfolio as a whole. The Weighted Average Life (WAL) of an instrument is often used to measure this risk, as it is based upon the legal final maturity rather than the next interest rate reset date.
Maturity and credit spread duration limits are complemented by other controls to manage credit spread risk. For example, a minimum credit quality will be set, which all assets in the portfolio must attain. This will likely make reference to a specific rating from one or more of the rating agencies. A credit rating is a credit rating agency’s view on the credit quality and security of a debt issuer. Historic data shows that the ‘higher’ the credit rating, the lower the probability of default and the lower the volatility in credit spreads. Money market funds will be restricted to only investing in debt issuers with ‘higher or highest’ credit ratings due to their objective of preservation of capital.
Most asset managers will not rely on credit ratings alone and will have their own credit analysts who will determine which individual debt issuers, asset classes or sectors within an asset class the portfolio managers can invest in, based on their opinion of the credit quality of a debt issuer or a sector. For example, a debt issuer may achieve the minimum credit ratings required under the investment guidelines, but may not meet the necessary credit quality threshold as determined by the in-house credit analyst, and will therefore not be eligible for the portfolio manager to invest in. An in-house credit analyst may also prohibit investment in certain asset classes or sectors within an asset class. For approved sectors, the credit process will focus on credit analysis at the individual asset level.
As noted in the previous paragraph, most asset managers will have their own credit analysts to assess credit risk at the asset class, sector and individual asset level. This assessment should be done independently of the portfolio management function to ensure there is no potential for a conflict of interest to arise. Typically, a credit policy will be set and the portfolio managers have to manage portfolios within its constraints. This is in addition to any specific constraints referenced in an individual fund or portfolio’s investment guidelines. Each analyst within the credit team will be responsible for particular sectors, e.g., there will typically be a European or global banks analyst, for analysing the sector and individual issuers within that sector. If a portfolio manager would like to invest in an issuer that has not been approved (for example, this is the first time an issuer has issued market debt), he or she will ask the appropriate analyst to review the issuer. Once this analysis is completed, the analyst will typically present his analysis to a Credit Committee that will ultimately determine whether the issuer will be approved. Prior to any approval, the portfolio manager will be restricted from investing in the issuer. This restriction is normally enforced automatically by the portfolio management system blocking any investment in debt by a non-approved issuer. [[[PAGE]]]
Individual issuers are assessed through consideration of the balance sheet and capital structure of the company, as well as the financial projections of future income and company growth. Reference will be made to any credit rating that has been awarded, but this should only form one aspect of the assessment. Following the analysis, a proprietary opinion on the credit quality of the issuer, and the outlook for that quality, will be formed.
The assessment of individual issuers should also consider the actions which various governments took during 2008 and 2009. With the variety of guarantee programmes in place, each of which has a bespoke legal structure, an in-depth analysis is required if any guarantee programme covers an issuer being analysed. This analysis should cover the scope of the guarantee in place, together with the potential ability of the sovereign to provide this guarantee. A view is also needed on the likely withdrawal of any government guarantees and timing of this potential withdrawal.
It is important that investors appreciate, enquire about and consider how credit risk is managed within a money market fund. The actual credit process followed by the fund combines a number of qualitative and quantitative criteria, utilises in-depth analysis of many factors, applies stress tests to the portfolio, and is regularly reviewed and updated. Only after all of this has been conducted is a fund manager able to select an instrument for inclusion within the fund.
The detailed credit assessment process performed by a money market fund is one of the fundamental benefits obtained by investors. When using money market funds for short-term cash management needs, investors should be reassured that the credit assessment that has been conducted is sufficiently robust to consistently deliver capital security and liquidity.
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