Risk-free investment?
In these unprecedented volatile and uncertain financial times we often hear people say that they wished that they had rather invested in a risk-free investment, often alluding to money market funds as being risk free. The sad news is that “….there is no risk-free[1] investment.”
If we forget about the equity market for a minute and focus our attention on money market funds, I will look at the risks money market funds are exposed to:
- Negative real interest rates
- Credit risk
- Liquidity risk
Negative real interest rates
This equates to the decline of purchasing power. If the rate of inflation exceeds after–tax interest rates, then the spending power of your capital in a money market fund will decline over time. This will happen even if you choose to reinvest your after-tax income. You might well say that you prefer to go backwards slowly and predictably rather than very abruptly as happened to equity markets in 2008. However, most investors probably do not want their capital to go backwards indefinitely.
When in trouble to meet their obligations, Governments around the globe might resort to printing money indiscriminately or engineer negative real interest rates. We would then end up being like Zimbabwe. If you had invested your money in an Zimbabwean money market you still would have had all your capital intact but unfortunately it would be worthless in terms of purchasing power.
Credit risk
Money markets invest in debt instruments or ‘IOUs’ which oblige the issuer of the IOU to repay a fixed money amount on a specified date within the next year. If the issuer were to go ‘bankrupt’ and default (in other words not being able to pay the full amount when it is due) the fund and the investors would bear a loss.
One way money market funds try to address credit risk is to invest the fund in a diversified portfolio of debt instruments issued by a range of issuers. This is done so that any potential losses arising from the default of any one issuer will be constrained to a limited portion of the fund’s portfolio.
The benefits of diversification will be tempered if the default of one issuer sets off further defaults by other issuers in a domino-effect crisis, as we saw happened globally in 2008. In the event of a systemic crisis like this, governments around the world have typically stepped in to shore up and stabilise the financial system.
Liquidity risk
Extreme circumstances can heighten liquidity risks. In most circumstances investors in money market funds can give one day’s notice of their intent to withdraw all their funds. All capital invested in a money market fund is not invested on a call deposit as the managers think it is unlikely that all the fund investors would suddenly want to withdraw all their funds on the same day.
By investing in longer dated paper fund managers can improve the yield earned by the fund and the investors.
Very importantly; in extreme circumstances (such as were experienced in the US money markets in 2008), withdrawals can be unexpectedly large, and this may force money market fund managers to sell its longer dated paper in order to fund the withdrawals. If this paper is sold at a loss (as there may be other money market funds all trying to sell the same paper at the same time), then that loss will be borne by the money market fund and the investors.
[1] Allan Gray’s December monthly news letter