Assessing risk in money market funds
Because they invest in fixed income securities, money market funds and ultra-short duration funds are subject to three main risks: interest rate risk, liquidity risk and credit risk.
Interest rate risk
Interest rate risk measures the impact of changes in rates on the securities held by money market funds.
If interest rates increase, the value of a money market fund’s investments generally declines, and vice versa. Securities with longer maturities typically offer higher yields, but have greater interest rate sensitivity.
Usually, changes in the value of fixed income securities will not affect cash income but may affect the value of an investment in the fund.
Weighted average maturity (WAM) and duration measure the sensitivity of a bond’s price to changes in interest rates. The interest rate risk of a fund can be mitigated by limiting the maximum WAM or duration of the product.
Liquidity risk can result from market volatility or from a lack of liquidity in underlying securities held by a fund.
Mitigating liquidity risk is most important for money market funds because they are meant to be used for daily cash needs.
There are two main types of liquidity risks faced by money market funds: funding liquidity risk (if the fund’s liquidity is insufficient to meet redemptions) and market liquidity risk (if market volatility forces funds to sell securities below the mark-to-market price in order to meet large redemptions or maintain regulatory limits).
To minimise funding liquidity risk, funds can maintain high overnight cash balances, build a strong ladder of maturities and institute cautious concentration limits to create a diversified investor base.
The latest regulations and rating requirements typically specify minimum requirements for daily liquid assets (DLA) and weekly liquid assets (WLA). Fund managers will typically hold higher DLA and WLA to provide an additional cushion against unexpected outflows.
Market liquidity risk can be mitigated by holding smaller concentrations of each issue with diversified maturities — particularly for less liquid securities — which can help minimise the impact of security price volatility. Money market funds typically pursue a buy-and-hold investment strategy, which can help them weather market liquidity risk, as securities mature at par. Maintaining strong broker relationships can also help ensure liquidity is maintained.
Credit risk measures the likelihood that issuers or counterparties will default or be downgraded.
Default risk is the failure to repay on securities, time deposits or repurchase agreements. Downgrade risk is the risk that the credit rating of a security or issuer may be reduced by a credit rating agency.
An increase in credit risk can lead to greater volatility in the price of the security, thereby impacting the value of the fund. A money market fund may also become a forced seller, because the security no longer meets regulatory or rating agency rules — while at the same time, the reduced rating may affect the security’s liquidity, making it more difficult for the fund to sell it.
Credit risk can be mitigated through the use of external or internal credit research, designed to monitor the credit quality of the issuer or counterparty. Credit rating agencies, either international or domestic, publish credit ratings that are an opinion on the default risk of a particular bond or issuer. Rating agencies also signal the likely future path of credit ratings with a “rating outlook” for the next six to 24 months and a “rating watch” for a three-month time horizon.
Rating agencies generally need to consider multiple factors and parties before taking rating action, which may limit their effectiveness. Therefore, a comprehensive, internal credit analysis process and credit risk management framework, that is integrated with a money market fund’s portfolio management, can minimise the risk of suffering unanticipated downgrades or defaults.
Stress testing to measure risk
Stress tests are the best method of risk analysis for money market funds and ultra-short duration funds, and are required by several regulators. Risk managers can use stress tests to ensure funds are conservatively managed with sufficient capacity to avoid a significant decline in the value of an investment in the fund.
Here is an example of a stress test that considers a money market funds’ sensitivity to changes in interest rates (x-axis), credit spreads (y-axis) and liquidity flows.
Credit risk management
Having an experienced and independent internal credit research team is increasingly critical to avoiding downside credit risks. Liquidity investors should therefore carefully review a fund manager’s credit research and credit risk management team and process when selecting a fund.
The credit risk management team’s primary function is establishing appropriate concentration and tenor limits based on the assigned internal credit rating to properly manage credit risks. Better-rated issuers generally receive higher concentration and tenor allocations
Securities with higher credit ratings are lower less risk than lower-rated securities. A strong internal credit analysis process will use independent internal ratings, in addition to considering those of the external rating agencies. These internal ratings are often more conservative than the external ones.
Credit risk can be managed by reducing the concentration of lower-rated securities in the fund. Each issuer is assigned a portfolio concentration limit corresponding to its internal rating, which is lower than the regulatory or rating agency limit and represents the ceiling.
Tenor is the length of time a security has until maturity. Each issuer is assigned a tenor limit corresponding to its internal rating that is lower than the regulatory or rating agency limit, which represents the ceiling. A shorter tenor minimises the risk that a security will be downgraded or default before maturity.
Five key fundamental credit considerations
1. Capital should be tangible and appropriate relative to earnings volatility.
2. Asset quality is assessed through the underlying credit quality and inherent liquidity of underlying assets.
3. Management should be consistent and operate with integrity.
4. Earnings are reviewed for consistency and quality over prolonged time periods.
5. Liquidity is assessed through matched funding, backup credit lines or a stable retail funding base (for banks).
Other factors to be considered in robust credit analysis
- Industry and operating trends, including cash flows, industry or product dominance and relative performance compared with peer groups, can be insightful in analyzing credit risk.
- Alternative repayment options, such as providing collateral, usually offer better recovery value in a credit event