By: Samantha Steyn, Chief Investment Officer, Cannon Asset Managers
It’s dangerous to only rely on yield as the basis for comparison.
Money market funds offer a useful parking bay for investors’ cash allocations, allowing you to earn better returns than bank rates with good liquidity. But when it comes to picking money market funds, investors tend to focus on one metric only: yield. By implication, this oversimplistic comparison assumes that aside from yield, all money market funds are equal – a common mistake which could place your investment at greater risk than you may have thought.
This focus on yield is especially problematic in today’s times, as a tough economic environment could see more business closures, which could directly impact the returns offered by those money market funds which carry high levels of such corporate debt. Given the current uncertain environment, it is therefore crucial to understand the nuances between various funds in order to ensure that you have selected the right money market fund for your needs. With that in mind, here is a simple guide to understanding and selecting money market funds.
The basics of money market funds
Beyond simply investing in cash, money market funds may also invest in other financial instruments such as bank paper, corporate debt, state-owned entity debt and government treasury bills. However, these funds are also specifically limited to investing in short-term debt with a limit of 13 months and a weighted maturity not exceeding 90 days. Investment risk is therefore generally lower than income funds which are able to invest in high-duration debt, which increases the chance of a default given the longer investment horizon.
So how are some money market funds able to offer more attractive yields than others? There are essentially two options:
1. Getting the forecasts on interest rates right; and
2. Including a higher ratio of lower-rated debt.
Analysing which of these two themes may be at play is key to better understanding and ultimately selecting a money market fund.
Option 1: Making the right interest rate call
Money market investments can either take the shape of floating instruments linked to the Johannesburg Interbank Average Rate (Jibar), which is South Africa’s money market rate, or fixed instruments. Whether the portfolio is tilted towards fixed or floating rate investments will then depend on the portfolio manager’s interest rate view. The outlook of interest rates (and inflation for that matter) is an ever-changing reality, and is directly linked to money market funds’ yield.
For example, going into 2020, very few people – if any – could have predicted that interest rates would fall by 3.0%. This meant that money market funds that had exposure to more floating rate investments would have immediately experienced a reduction in yield. By contrast, funds with more fixed rate investments would have been able to better protect themselves – at least temporarily – against the aggressive interest rate cuts. The Cannon Money Market H4 Fund, for instance, had 75% fixed rate investments going into 2020, which gave the fund a considerable yield advantage.
Figure 1: Money market yield curve, December 2019 to October 2020
Source: Cannon Asset Managers (2020)
As can be seen from Figure 1, money market yields have fallen considerably since December 2019. Not only that, but the yield curve has also flattened out as well, with the 12-month differential declining by 90 basis points over the course of 2020.
Understanding the nature of the underlying investments will therefore shed further light on the yields when comparing funds. Also important to note is that as investments mature, managers are being forced to reinvest at today’s lower yields. The question on each fund manager’s mind is therefore when will interest rates start increasing? Getting this timing right will be result in a relatively more attractive yield until the next interest rate move, and so the cycle continues.
Option 2: Introducing a higher ratio of lower-rated debt
Lower-rated debt carries a higher risk of default or non-payment, and therefore offers higher yields to investors as compensation for the additional risk at play. Corporate and state-owned entity investments, for instance, naturally come with higher yields in order to compensate investors for the higher associated investment risk.
So the allocation of fixed versus floating rate investments can cause a significant difference or dispersion in fund yields (especially when a black-swan event such as a pandemic sees a 300 basis point cut in interest rates within the space of a few months). But, overall, if you see a money market fund offering a relatively high yield, you would be wise to generally exercise some caution. While the yield may appear attractively high, this may be accompanied by increased risk.
When choosing a money market fund, investors should first analyse the fund’s minimum disclosure documents in order to assess the allocation of the fund’s investments to more risky entities. This is especially important in current times where companies are experiencing a drop-off in revenues and cash flows and potentially leading to more business closures, a rising number of defaults and the inability to service debt. In a default scenario, it is not impossible for money market funds to experience capital loss.
Ultimately, money market funds are a great place to save for the short-term. Just be sure you understand the underlying make-up of the fund you have selected, and that you are satisfied with the nature of the investments and the amount of investment risk involved.