BofA Global Capital Management recently produced a Perspectives on Liquidity "white paper" entitled, "Putting Risk Under the Microscope." Subtitled, "Now More Than Ever, Investors Need to Evaluate the Risks in Money Market Funds," the piece was written by Head of Portfolio Management, Money Market Funds Dale Albright. It says, "Over the past several years, money market fund investors have been barraged by market disruptions ranging from the fall of Lehman Brothers and the subsequent collapse of the Reserve Primary Fund to the Greek debt crisis and fears of wider contagion in Europe. Little wonder, then, that 77% of treasury professionals recently surveyed by the Association of Financial Professionals cited principal protection as their top priority, while almost 80% reported they were keeping the vast majority of their cash in historically "safe" bank deposits, government debt and money market funds."
Albright explains, "Given their heightened risk aversion, it only makes sense that investors would emphasize traditionally stable investments. Yet for all of their sensitivity to risk, many investors place significant sums in money market funds -- a key component of many cash investment programs -- without fully vetting the funds' risks. Some may avoid that exercise because they're daunted by the challenges inherent in parsing portfolio risk. Others may believe that enhanced regulations limiting risk-taking by fund managers obviate the need to conduct such due diligence. The reality, however, is that both the amount and type of investment risk vary from fund to fund, and with headline risk roiling the financial markets, you need to understand the risks you're assuming when you invest in a money fund."
He tells us, "When we speak of evaluating a money market fund's "risk," we're talking primarily about assessing the three major components of portfolio risk -- credit risk, liquidity/redemption risk and interest rate risk. The major drivers of performance and portfolio volatility, these risks can be difficult to analyze because they are increasingly inter-connected. That said, it is vital to conduct at least a rudimentary analysis of them when screening funds for your investment portfolio. This is especially true during the current low-rate environment, which could incent fund managers to take on additional risk to boost yield."
The white paper continues, "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. An obvious example of a security with high credit risk is the sovereign debt of Greece, which investors fear is in danger of default due to the country's deteriorating finances and anemic economy. In contrast, Germany is considered to have much lower credit risk -- as evidenced by its stronger credit rating and lower risk premium relative to that of Greek issues."
It says, "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 U.S. Treasuries, federal agency debt and AAA-rated U.S. 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, such as Irish and Spanish sovereign debt or Eurozone banks with large exposures to the sovereign debt of those countries."
Albright continues, "The risk of default or downgrade is but one facet of credit risk. A more subtle and somewhat more arcane element of credit risk is "duration of credit risk." The key measure of a fund's duration of credit risk is its weighted-average life (WAL), which reflects the weighted-average final maturity of all the securities in the fund's portfolio. All things being equal, a money market fund portfolio with a long WAL is more risky than one with a shorter WAL because in the event of significant spread widening, the former would be more vulnerable to declines in the prices of its holdings."
He writes, "Recognizing the impact duration of credit risk has on the stability of money market funds, the Securities and Exchange Commission (SEC) and the Institutional Money Market Fund Association (IMMFA), which establishes guidelines for rated European money market funds, have limited the maximum WAL to 120 days. Additionally, the SEC pared the amount of credit risk funds can assume by reducing the maximum amount of Tier II paper they can hold to 3% of total assets and by limiting the maturity of that paper to 45 days or less."
BofA Global's piece also says, "Liquidity/redemption risk measures the probability of a fund being able -- or unable -- to meet investor redemptions when requested. To effectively evaluate a money market fund's liquidity risk, you must review several key metrics: The absolute levels of daily and weekly liquidity; The ratio of daily and weekly liquidity to the sum of the fund's largest shareholders (shareholder concentration); The liquidity characteristics of the fund's holdings; and, The fund's WAL. Daily and weekly liquidity clearly are important because they provide the cash necessary to meet redemptions. That said, absolute levels of available liquidity are not the best metric of a fund's liquidity risk because that measure does not capture the probability of a significant liquidity drawdown due to large redemptions."
It explains, "A fund's liquidity profile will reflect, to some degree, the liquidity profile of its holdings. If, for example, a fund has a large allocation to widely traded assets for which there is a deep market -- U.S. Treasuries and high-quality corporates come to mind -- it likely would be viewed as having better liquidity than a fund with large exposures to less liquid assets. (This assumes that other drivers of liquidity -- shareholder concentration, for example -- are the same for both funds.) In addition, money market funds may have an allocation to securities that are very liquid, e.g., federal agency coupon notes, but not liquid enough in the view of the SEC to meet the agency's definition of a security offering overnight or weekly liquidity."
Albright writes, "Another important metric of a fund's liquidity is its WAL, which, again, is the weighted-average final maturity of the securities in the fund's portfolio. Portfolios with short WALs, say 60 days, likely would have a large exposure to short-dated notes, i.e., those with 30-, 60- and 90-day maturities. Additionally, portfolios with relatively low WALs tend to have less exposure to floating-rate securities, notes that reset to the interest rate of a daily, monthly or quarterly index."
He also tells us, "Interest rate risk refers to the probability of a security's (or a portfolio’s) value rising or falling due to a change in absolute rates or a change in the relationship among rates. For purposes of illustration, assume the Federal Reserve increases the federal funds rate by 50 basis points. The price of existing short-term debt would drop because investors theoretically would sell their holdings to swap into new credits offering yields that reflect the Fed's rate increase. The primary metric of a money market fund’s interest rate risk is its weighted-average maturity (WAM), which measures the average time until the holdings in a fund portfolio can reset to higher levels, either because the portfolio's floating-rate securities reset or because its other credits mature."
Finally, Albright adds, "Prior to the global financial crisis, most investors believed money market funds were as much a safe haven during volatile markets as U.S. Treasuries. The breaking of the buck by the Reserve Primary Fund and the subsequent run on money funds in 2008 reminded them that no investment -- not even a money fund -- is inherently "safe." Today many investors assume that the more stringent regulations imposed upon fund managers over the past two years have all but eliminated risk differentials among funds. That notion could well become a casualty of the next crisis as investors learn the hard way that the risk appetites of fund managers still vary. The fact remains that when weighing your investment options, you still need to ascertain the amount and composition of funds' portfolio risk. To do less is to risk discovering during the next market disruption that your fund manager's tolerance for risk is not in sync with your own."
