The Instruments Purchased by a Money Market Fund

Published: July 01, 2010

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. [[[PAGE]]]

Floating rate notes (FRNs)
A bond that pays a variable rate of interest. The interest rate payable is revised on a periodic basis, and typically follows an index with a spread applied (e.g., Libor + 0.20%). The competitiveness of the FRN can depend on how frequently the interest rate is reset; a shorter reset period will react more quickly to any changes in interest rates than a longer reset.

With a fund’s weighted average maturity (WAM) being based on next interest reset dates and the weighted average final maturity (WAFM) on the legal final maturity of the instrument, higher levels of FRNs can result in a greater disparity between the WAM and WAFM of the fund.

Medium term notes (MTNs)
A bond with an original maturity of between 5 and 10 years. MTNs can pay interest on either a fixed or floating (variable) rate basis, and may be issued with options for the issuer or the investor which give a right to redeem before the maturity date. Money market funds could not purchase such an instrument when originally issued, as the maturity is too long, but may acquire one that is near maturity.

Asset backed commercial paper (ABCP)
A form of commercial paper that is backed by a range of collateral, such as trade receivables or mortgage securities. ABCP is generally issued by banks or other financial institutions and typically has a maturity of between 90 and 180 days. It has a more complex structure than traditional CP, due to the collateral backing, and may pay a slightly higher return as it is not purchased by all corporate investors.

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

The bank or other financial institution wishing to issue the ABCP will sell the underlying assets to a bankruptcy-remote entity, i.e. a special purpose vehicle (SPV). The SPV which issues the ABCP will then be legally separate from the bank. However, there may be liquidity support offered by the bank to the SPV, as the secondary market for ABCP is limited.

Asset backed securities (ABS)
A security where the income payable to the investor is provided from the returns generated by a pool of underlying assets. These assets could be groups of credit cards or car loans, which are generally small and illiquid and could not be sold individually. As with ABCP, the ABS is issued by a SPV.

The liquidity of ABS can vary, and the credit analysis prior to purchase should consider the underlying assets as well as any credit enhancements supplied to the security by the issuer.

Various instrument types have different risks associated with them, and the precise risk of a specific instrument will further depend on the issuer. Whilst money market funds may purchase similar instruments, no two money market funds will exhibit the same risk profile. Understanding the nature of the investment and the risk associated with it will help investors identify funds whose risk profile corresponds with their investment objectives.   

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Article Last Updated: May 07, 2024

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