The Credit Processes Operated by a Money Market Fund
by Jonathan Curry, IMMFA Technical Committee Chair
When investing cash, investors seek to preserve the security of their capital. One of the principal determinants of whether any investment is able to maintain capital value is the credit quality of that investment. With this in mind, and based upon recent experiences, investors in money market funds should now have a greater interest in credit risk and how this risk is managed.
Money market funds provide a viable means of outsourcing short-term cash management. One advantage of these funds is the dedicated resources employed by the fund manager, which will include credit analysts. The depth of these resources is often significantly greater than that which could be accessed by the investor, meaning that investors in these funds benefit from additional credit capabilities.
To understand how credit risk is managed, an investor can review the credit analysis process that is performed by the money market fund manager. Whilst the detail of any credit assessment will vary by fund manager, there are some generic aspects which are relatively consistent. An overview of these aspects is provided below, and further information on the specific process employed can always be obtained directly from any fund manager.
Credit assessment is one of the factors considered when selecting instruments for inclusion in a money market fund. Before providing an overview of the credit assessment process, let’s define what credit risk is.
Credit spread risk
Credit spread risk is a key risk to be managed in a money market fund. ‘Credit spread’ is the additional return earned above the ‘risk free rate of return’ and is a reflection of a bond issuer’s creditworthiness or its perceived ability to pay back principal and interest in a timely manner. For example, if we assume the rate that Germany as a sovereign can borrow money in the market is an example of a risk free rate, the additional premium that Volkswagen needs to pay investors to compensate them for the additional risk of investing in Volkswagen debt versus German sovereign debt is known as the credit spread. This spread will fluctuate depending on the market’s view of the relative creditworthiness of, in this example, Volkswagen and the German government.
As the spread moves, so too does the yield. If the credit spread widens (increases), there is a greater risk associated with the asset than with the risk-free rate. To further compensate investors for this increase in risk, the yield payable must also increase. Although obtaining a higher yield may be positive for investors in the bonds, existing bondholders will lose money. This happens because when yields increase, prices fall – an inverse relationship. The impact of a rise in yield on existing bondholders can be explained using an example of a 5-year maturity UK government bond (Gilt) originally offered to investors at a price of 100.00 and a coupon of 5%. For these purposes let’s assume that on the following day 5-year UK Gilt yields increase by 1% to 6%. The gilt in our example will now be less attractive to investors as the coupon paid (5%) is lower than the rate that is now available in the market. The price of the asset would have to fall below 100.00 to compensate investors for the lower coupon paid.
Money market fund managers must carefully manage credit spread risk in order to avoid having the fund’s investments lose value due to yield increases. One way in which this is achieved is to manage the duration of the assets in the fund. The longer the maturity of an asset, the higher the potential for movements in credit spreads to impact the value of that asset. For example, a Volkswagen bond with a duration of one year will be more sensitive to changes in credit spreads than a Volkswagen bond with a duration of six months. Managing the duration of the assets in the portfolio is then key to also managing credit spread risk.