Representing the true risk of money market

Most investors consider Money Market and Income Funds to be low risk and assign a low probability to losing their money (capital and/or income). This, in part, is assisted by the accounting surrounding these Funds in South Africa, but investors should consider the consequence if a larger majority of the investor community required to withdraw at the same time whether the Fixed or Constant NAV (Net Asset Value) of 1.00 of the Money Market Fund would still hold true.

On Monday 15 September 2008 Lehman Brother failed and one day later the Reserve Primary Fund “broke the buck”, even though it only held 1.2 percent of Lehman short-term debt. Immediately investors began to withdraw from other money market Funds, which accounted to 15 percent of money market fund assets. This resulted in other Funds almost breaking the buck, being rescued by their sponsors.

This pressure arose not out of bankruptcy concerns but from risk-fleeing investors who want to switch to Treasuries. Their redemptions exhausted the Funds’ cash reserves and as the redemption requests accelerated, Funds faced the prospect of selling assets at “fire sale prices”. This realisation would have seen money market funds below a NAV of 1.00; and in the case of the Reserve Primary Fund the projected loss on its Lehman holdings implied a NAV of 0.97.

The US Government finally rode to the rescue and announced a US government guarantee on all existing deposits in participating money market Fund deposits to the tune of $0.5 trillion. On the same day the US Federal Reserve announced emergency powers to create a credit facility to fund no-risk bank purchases of asset-backed commercial paper from the money market Funds.

The large scale government interventions did successfully halt the run and stabilised money markets, but raises the question whether South African money market industry – like many other parts of the World – should shift towards floating NAV with the opinion that the dynamics of a fixed NAV Fundsignificantly translates into run risk.

Floating NAV has been a favoured reform strategy in Europe and US because it eliminates the distortion between money market funds and other funds. This change would condition investors to understand that the value of market instruments fluctuates and that a decline in market prices does not necessarily signal an imminent default on portfolio securitiesand provides investors with a more realistic expectation of “safety”.

South Africans have often cited how their money management industry was relatively unscathed by global events in 2008, however recent events have shown their situation to be no different.

From 1 August 2014 to 8 August 2014, African Bank offshore dollar bonds fell precipitously from $0.96 to $0.50; initially its equity price didn’t reflect any concerns until 6 August 2014 when it traded from R6.88 to close at R2.70. The following day it closed at R0.50. Even at this point, the investment community still appeared to be in denial given various reports that suggested “it would all turn out okay”.

By Sunday 10 August 2014, African Bank required emergency support from the Reserve Bank after this sudden destruction in value. As a result holders of senior and wholesale debt instruments issued by African Bank have had their holdings written down to 90% of face value, while subordinated instruments have been written down to zero.

On Monday 11 August 2014 money-market investors were at risk to losses on African Bank debt, including facing capital losses as money managers slashed interest payments to offset write-downs of debt; including potentially a rebate of management fees to reduce the impact to investors.

Some investors have awoken a little poorer this week and undoubtedly will not look at these fixed income investments as a fail-safe way to save money.

It surely must be difficult for the man-in-the-street to quantifyhow the fund management industry reached the conclusion that “we will not break the buck”, or ASISA regarded the impact to “fixed interest portfolios to African Bank stock and debt instruments is minimal”, when Fitch Ratings state that“the high level of concentration in these Funds is inconsistent with the profile for a MM Fund.”

Fitch Ratings has downgraded some money market funds by up to 4 notches to reflect the impact of African Bank price exposure on price and income of these Funds. The worst hit Fund recognised a capital loss (that is, they did “break the buck”). The worst-hit Fund had “the highest, longest-dated exposure to African Bank” and that “Fitch considers the level of loss incurred inconsistent with a highly rated, stable unit value, money market Fund.”

Was the pressure to generate yield, or outperform their peers, so great that they put retail investors’ money at greater risk? Which begs the question as to whether they were aware of the risks they had in their portfolios?

As a result of the GFC, Funds in the US and Europe must undergo stress tests to verify their ability to maintain a stable NAV under adverse conditions, and are required to track and disclose the NAV based on the market value of underlying holdings and to release that information.

As both the Lehman – and now African Bank – has shown, there is no free lunch for the man-in-the-street and the time is right for floating NAV and NAV disclosure requirements in South Africa. A shift to a NAV which rises and falls on a daily basis doesn’t seem such a bad idea when you consider all other unit trust funds operate on this basis.

It's easy to think that money market funds are very safe and a good option for an investor that wants a higher return than a bank account can provide, and an easy place to allocate cash awaiting future investment with a high level of liquidity. Although it's viewed as extremely unlikely that your money market fund will break the buck, it's a possibility that shouldn't be dismissed when the right conditions arise.