Money Market Funds

Money market funds are debt funds that invest in money market securities having maturities up to one year. Money market securities are short term assets that are issued and traded in the money market.

In order to understand how money market funds work, it is necessary to understand the concept of duration in a bond fund. The duration of a fund impacts its investments and sources of earnings.

• Understanding Duration:

  The duration of a debt fund is directly linked to the maturity of bonds in its portfolio. Funds holding long-maturity bonds have higher durations as compared to funds that hold mainly short-term securities. Duration is a measure of how much a fund's value fluctuates in response to changes in market interest rates. The higher the duration, the more volatile the fund value, and the greater its interest rate risk. SEBI does not mandate any duration norms for money market funds (as it does for the low duration or short duration funds), but since money market funds invest in money market securities- which have a maximum maturity of one year- the duration of these funds is always less than one year. That is why money market funds are less volatile and carry low-interest rate risk. In terms of interest rate risk, money market funds are positioned slightly below low duration funds.

• Where do money market funds invest?:

  Money market funds invest in a range of money market securities such as TREPs, commercial paper, certificates of deposits, treasury bills, government securities with residual maturity less than a year, and commercial bills. There are no SEBI norms about the credit quality of debt held by a money market fund, but since money market securities generally have a low probability of default, these funds are considered to have low credit risk. The only credit exposure comes from investments in commercial paper or commercial bills issued by the corporate sector.

• Sources of Earnings:

  Money market funds earn through interest as well as capital appreciation. Interest income is earned through interest payments by the securities held by the fund. There is some potential for generating capital gains also. Money market funds can actively manage fund duration to benefit from interest rate movements in the market. When interest rates fall in the market, such funds are likely to push up duration by increasing their exposure to longer-maturity debt; thereby benefiting from a rise in fund value. When interest rates go up, the fund is likely to hold more short-term debt, in order to minimize capital losses. But remember that money market funds cannot invest in bonds with maturities longer than one year- implying that they have a limited ability to increase duration and make capital gains. This also means that money market funds tend to be relatively less volatile.

• Low/Moderately Low Risk:

  Money market funds carry a low or moderately low level of interest rate risk, as they hold securities with maturities up to one year. Since they invest in money market securities only, these funds also have low credit risk. As a result, money market funds typically provide stable returns with low volatility.

• Easy access to money market:

  Retail investors cannot directly invest in money market instruments. Money market funds enable convenient access to a range of money market securities. Unlike liquid funds, which invest in money market securities with maturities up to 91 days, money market funds can hold securities with maturities up to 1 year. Thus, investors in money market funds are exposed to a wider maturity range of money market instruments and have the potential to earn higher returns. In addition, the funds offer easy liquidity, and usually have no lock-in period or exit charges.

• Steady Returns:

  Money market funds generate steady returns through cycles of interest rate tightening and easing, because fund values do not change much in response to changes in market rates. When market rates rise, the funds earn mainly through higher interest income. When market rates decline, they make up for lower interest income by generating capital gains. Unlike other short-duration funds (such as ultra-short /low duration funds), money market funds do not hold lower-rated debt to push up yields. The low credit risk also ensures that the fund is relatively less volatile.

• Investors who want to park short term surpluses:

  Since money market funds offer stable returns, they are ideal for investors who want to park surpluses for short term periods ranging from one month to one year. The invested corpus is likely to remain safe and earn a market yield until deployed in other avenues.

• Investors who want regular income in the short term:

  Money market funds provide regular income with the benefits of stability and liquidity. Investors with a low risk appetite can allocate a part of their portfolio to these funds, and use an SWP to create a stream of income flows.

• Investors who want an alternate short-term savings instrument :

  Money market funds earn more than savings deposits, as they generate income through interest payments as well as capital gains. They usually generate returns higher than liquid or overnight funds, because they invest in relatively longer-term debt.

• Medium to Route investments in Equity Funds

  Money market funds can be used to route investments into an equity fund or hybrid fund through an STP. While it is more common to use liquid funds for this purpose, investors who do not mind taking on slightly higher risk can benefit from the higher return potential of money market funds.

There are two main concerns with investing in money market funds. First, these funds typically invest in short term assets that have a low probability of default, but that does not mean that there is no credit risk! Recently, there were some instances of highly rated commercial paper being downgraded sharply when the issuing company was unable to pay its interest dues. A money market fund that holds a significant amount of defaulting/downgraded debt paper is likely to see a large erosion in fund value.

Second, while money market funds aim to generate stable and regular income, there is no guarantee that this objective will be realized. Fund values will fluctuate up and down when interest rates change in the markets. If the fund manager gets his or her interest rate predictions wrong a few times, the fund may end up with a yield considerably below its peers. Thus, investors must choose money market funds that have shown consistently good performance and have delivered steady returns over time.

There are two ways in which investors can earn from money market funds: dividend income and capital gains. From financial year 2020-21 investors will pay tax on dividend as per their tax bracket. Capital gain is the difference between price at which units were purchased and price at which they were redeemed or sold. Capital gains can be taxed as short term or long-term capital gain depending on the length of time for which an investor holds the fund.

• Short term capital gains:

  If an investor stays invested or a period up to 3 years, capital gains on redemption/sale are considered as short-term capital gains and taxed at the income tax slab rate applicable to the investor.

• Long term capital gains:

  If a money market fund is redeemed/sold after being held for more than 3 years, it is considered as long-term capital gain, and the investor gets the benefit of "indexation." This means that the purchase price is increased to adjust for inflation (using an index provided by the Government) before calculating the capital gain. Long term capital gains are currently taxed at a rate of 20%.

Money market funds are steady return products, with a low risk of default. Since these funds invest only in money market securities- which tend to have low credit risk- they are usually evaluated on the basis of returns, expense and interest rate risk.

• Return:

  It is appropriate to evaluate money market funds on the basis of 6-month or 1-year returns as these funds hold debt with a maturity of one year or less. A well performing money market fund will outperform its peers and the benchmark, and do so consistently over different market scenarios. Consistency in returns shows skillful duration management.

• Expense:

  The expense ratio is the annual amount charged by a mutual fund for managing the portfolio. The final return to the investor is computed by subtracting the expense ratio; hence investors must monitor the expense ratio carefully. An expense ratio that goes up suddenly or tends to be higher than that of peer funds calls for deeper examination.

• Interest rate risk:

  Money market funds can manage the duration of the fund to benefit from changes in market interest rates. The extent of interest rate risk can be judged by tracking the volatility in fund value; higher volatility means that the fund is exposed to greater interest rate risk. Investors can also track monthly durations published in the monthly fund fact sheets.

The table below shows the top 5 money market funds ranked by 6-month and 1-year return. Note that 6-month returns need to be annualized to make them comparable with other returns; for example, a 4.70% return over 6 months can be annualized to 4.70 x 12/6 = 9.4%.

The range of returns is less than 0.5%, showing that the top-performing money market funds earned similar returns in this period. The expense ratios are also quite similar across these funds. In other words, money market funds appear to be fairly homogenous in terms of returns and costs.

Investors can evaluate interest rate risk by tracking fund durations over time. It must be remembered that funds that actively manage durations in response to changes in market interest rates may generate higher returns but are also likely to show the most volatility in fund value. Investors must ensure that the risk exposure of the fund matches their own risk tolerance. And finally, investors should also consider qualitative criteria such as the reputation of the fund house and experience of fund managers while evaluating a money market fund.

• Money market funds are debt funds that invest in money market securities with a maximum maturity of one year.
• Money market funds usually have durations less than one year. Hence they show low fund volatility. They are positioned below low duration funds in terms of interest rate risk.
• Money market funds usually invest in short-term, high-quality debt, though investment in commercial paper or commercial bills can create exposure to credit risk.
• Money market funds earn through interest income and capital gains on their debt holdings.
• Money market funds offer stable returns for a low or moderately low risk. Investors with low or moderate risk appetite can opt for these funds as an alternative to savings deposits or liquid funds.
• Money market funds are most suitable for investors who need to park surpluses temporarily for an investment horizon higher than one month, those looking for regular income at moderate risk, and for use as a medium to route funds into other long-term funds.