Why Do Money Market Funds Break the Buck?

In a money market fund, investors purchase securities that are held by the brokerage firm. On the other hand, in a money market deposit account, the investor deposits their money in a bank. In this case, the bank invests the money and pays the investor the agreed-upon return. It's worth noting that while the FDIC does not insure money market funds, it does guarantee money market deposit accounts.

Basics

Money market funds are a secure repository for unallocated funds, often viewed as a haven for cash awaiting investment. These funds present a low-risk, low-return opportunity involving investing in a stable pool comprising highly secure, short-term debt instruments with exceptional liquidity.

The primary objective of money market funds is to maintain stability and security, ensuring the preservation of capital and a constant net asset value (NAV) at $1. The concept of "breaking the buck" emerges when the NAV falls below $1, signifying potential losses for investors as a portion of the initial investment dissipates. Although breaking the buck is infrequent, it is essential to note that money market funds lack FDIC insurance, exposing investors to the possibility of financial losses.

Security Concerns in Money Market Investments

Despite the perceived safety of money market funds resembling savings accounts, the 2008 financial crisis raised questions about their stability. Until that point, the money market's history, dating back to 1971, witnessed fewer than a handful of funds breaking the buck. A notable incident occurred in 1994 when an institutional money market fund invested in adjustable-rate securities faced challenges amid rising interest rates, paying out only 96 cents per dollar invested. However, individual investors remained unaffected for 37 years.

In the aftermath of Lehman Brothers' bankruptcy filing in 2008, a money market fund wrote off Lehman-issued debt, causing its value to drop to 97 cents and triggering concerns of a broader market panic. Subsequently, another fund announced liquidation due to redemptions. However, the U.S. Treasury swiftly responded by introducing a program to insure publicly offered money market funds, ensuring investor protection up to $1 NAV in case of a fund breaking the buck.

Ensuring Security: Factors Contributing to the Safety of Money Market Funds

The safety track record of money market funds is underpinned by three key factors:

1. Short-Term Debt Maturity: The portfolio primarily consists of short-term debt (397 days or less), maintaining a weighted average portfolio maturity of 90 days or less. This flexibility enables swift adjustments to mitigate risks in response to changing interest rate environments.
2. High Credit Quality: Money market funds are limited to investing in the highest credit quality, typically AAA-rated debt. Diversification strategies ensure that no more than 5% of funds are invested with a single issuer (excluding government), minimizing the impact of credit downgrades on the overall fund.
3. Institutional Market Participants: The market comprises large professional institutions with a vested interest in upholding a NAV above $1. Rare instances of funds breaking the buck underscore the severe consequences for a firm's reputation. Firms, aware of the potential devastation and loss of investor confidence, go to great lengths to avoid such scenarios, reinforcing the safety of investors.

Managing Risks in Money Market Investments

Preparedness for potential risks is essential when considering money market funds, as unforeseen events, though rare, can exert pressure on their stability. Examples include abrupt interest rate shifts, significant credit quality downgrades for multiple firms, and unanticipated increases in redemptions.

To enhance risk mitigation and safeguard investments, investors should:

1. Scrutinize Fund Holdings: Gain a clear understanding of the fund's portfolio. If the investment appears complex or unclear, consider exploring alternative funds.
2. Correlate Return With Risk: Recognize the correlation between return and risk. Higher returns are typically associated with greater risks. Opting for funds with lower fees provides an avenue for potential increased returns without additional risk.
3. Consider Firm Size: Larger firms tend to be better funded, exhibiting greater resilience to short-term market volatility than smaller counterparts. Some fund companies may even cover losses to prevent a fund from breaking the buck. Generally, larger entities offer a safer investment environment.

Clarifying Money Market Distinctions

In the financial landscape, money market funds, alternatively referred to as "money funds" or "money market mutual funds," should not be conflated with the analogous-sounding money market deposit accounts provided by U.S. banks. The primary distinction is that money market funds constitute assets held by a brokerage or potentially a bank, while money market deposit accounts represent liabilities for a bank. Unlike money market funds, banks can invest the funds from deposit accounts at their discretion, potentially venturing into riskier investments beyond money market securities.

Banks profit from money market deposit accounts by investing funds at higher rates than those paid on the accounts. Notably, money market deposit accounts offered by banks are FDIC-insured, ensuring a higher safety level than money market funds. While these accounts may offer competitive yields similar to money market funds, they could have restricted transactions or minimum balance requirements.

Conclusion

Before the 2008 financial crisis, only a few minor institutional funds experienced a break in the buck over the previous 37 years. The crisis prompted the U.S. government to intervene, offering insurance for any money market fund, instilling the expectation of a repeat intervention in the face of similar situations.

The apparent safety of money market funds makes them an attractive choice for investors seeking higher returns than traditional bank accounts, providing a convenient avenue for cash allocation with ample liquidity. While a money market fund is unlikely to break the buck, the potential should not be dismissed under specific conditions.