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The writer is a former investment banker and author of ‘Power Failure: The Rise and Fall of an American Icon’
In the past decade, a substantial amount of money has poured into US money-market mutual funds, which were traditionally considered a safe short-term investment option. Currently, these funds hold approximately $5.6tn in cash, a significant increase from $2.6tn a decade ago, according to the Investment Company Institute.
Is this cause for concern or simply a reflection of investors’ inclination to seek higher yields by taking on more risk? Crane Data reports that money-market funds offering the highest yields now provide investors with an annual return of around 5 per cent.
Investors have taken notice. Since the Federal Reserve began increasing interest rates in March 2022, $862bn in bank deposits has been withdrawn and redirected to other investments, including money-market funds, surpassing the amount withdrawn from major banks in the aftermath of the 2008 financial crisis by a factor of 12. Given that JPMorgan Chase, the largest US bank, offers depositors an annual interest rate of 0.01 percentage points for checking accounts, these investment decisions seem logical.
However, are money-market funds as safe as they are perceived to be? The industry has implemented significant reforms to enhance safety since the financial crisis. These reforms have influenced investor behavior, resulting in a shift towards government funds, which exclusively invest in government debt, as opposed to prime funds, which previously invested in a broader range of assets. Of the $5.6tn in money-market funds, the majority ($4.6tn) is allocated to safer government funds.
Nonetheless, as highlighted by the Silicon Valley Bank collapse earlier this year, there are still risks in investing in government securities, particularly in a rising interest-rate environment where rapid outflows could force managers to sell assets, resulting in losses.
The surge of cash flowing into money-market funds has raised concerns among several individuals on Wall Street. “No one is willing to speak the truth,” a seasoned finance veteran confessed in an email. “There is an excessive amount of money invested in these funds, and there are no safety nets. People have panickedly moved from banks to higher-yielding instruments without fully understanding them.”
Furthermore, Treasury Secretary Janet Yellen acknowledged the vulnerabilities of money-market funds to runs and fire sales, stating, “If there is any place where the vulnerabilities of the system to runs and fire sales have been clear-cut, it is money market funds.”
The problem with money-market funds lies in their lack of insurance. While bank deposits are insured by the Federal Deposit Insurance Corporation, money-market funds are not. Government money-market funds carry minimal risk of losing money, but prime funds offer higher returns with increased risk.
For instance, the Dreyfus Money Market Fund, managed by Bank of New York Mellon for 41 years, currently provides investors with a 5 per cent annual yield. However, Dreyfus explicitly states that an investment in the fund is not equivalent to a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The disclaimer serves as a clear warning. Nevertheless, investors have flocked to this and similar funds in an attempt to capture higher yields.
It is essential to remember the Reserve Primary Fund’s “broke the buck” incident during the 2008 financial crisis. This prominent money-market fund plummeted in value due to the rapid decline of supposedly safe investments, such as Lehman Brothers’ bonds, causing the fund to trade as low as 97 cents on the dollar. It was one of the few instances where a money-market fund fell below par value, further adding to the already nervous financial system.
History has demonstrated the occurrence of financial crises, which manifest with some regularity. While money-market funds have become safer, there are still risks that necessitate careful monitoring.
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