Read this article to understand:
- The role of MMFs as a cash management tool
- The risks facing MMFs and how these are actively managed
- The yield opportunity in MMFs
Cash management is truly universal – be it retail, corporate or institutional. For many investors across this spectrum, bank deposits will be their core cash management tool. But other tools are also available and can provide complementary solutions.
Money market funds (MMFs) are an efficient tool for optimising cash holdings. They provide utility value, diversification, active risk management and access to market yields. With yields rising, MMF are an increasingly attractive option. For euro investors, after years of negative rates, MMFs now offer highly competitive yields.
In this guide, we will explore:
- The role of MMFs in cash management
- How MMFs manage risk
- MMFs’ yield generation potential
- ESG considerations
- MMF regulation
- The history and distribution of MMFs
The opportunity in brief
MMFs offer diversified high-credit-quality exposure and competitive yields that reset quickly to prevailing overnight rates. This combination means they can play a core role in cash optimisation.
The role of MMFs in cash management
MMFs are a specific category of highly regulated mutual funds, which invest in diversified portfolios of high credit quality and short-maturity fixed income securities. They are widely used by corporate treasurers and institutional investors as part of their cash management strategies.
Many investors use sophisticated cash forecasting techniques to project future cashflows. Based on this analysis, they will typically segment their cash into three buckets:
- Operating cash: Cash held for daily use and, as a result, the balance is likely to be highly variable.
- Reserve cash: Cash balances for use on a less frequent or periodic basis. A good example is cash held in advance of making a coupon payment on a bond. While this cash may be dipped into periodically, it tends to be quite stable.
- Strategic cash: Cash held for long periods, typically for strategic purposes. This category is broad: in some cases, it may be a “rainy day fund” for unexpectedly difficult market conditions, or held in preparation for major activity, such as M&A.
Figure 1: Cash segmentation
Source: Aviva Investors, February 2023
MMFs are mostly used for operating and reserve cash. Some investors may also use complementary vehicles such as “standard” MMFs and ultra-short-duration bond funds for reserve and strategic cash.
MMFs are well suited to operating cash needs because they can offer daily liquidity and stable values in most market conditions. This means investors can subscribe or redeem daily, with cash paid out the same day.
Figure 2: Comparing MMFs with bank deposits
|Credit quality||Redemption frequency||Maturity|| |
|MMF||AAA rated||Daily||Underlying assets up to 397 days, portfolio average up to 120 days||Many underlying exposures||Variable, in-line with market cash rates|
|Bank deposit||Varies; senior instruments usually in the AA to A range, unless government guaranteed||Varies depending on the type of account, from instant access through to notice accounts||Varies, depending on the account and its terms||Single bank exposure||Fixed or variable depending on the account|
Source: Aviva Investors, February 2023
How MMFs manage risks
MMFs are not risk-free. However, their risk profile is low, owing to the types of security they buy, diversification of their portfolios and the active management of risks.
MMFs maintain high levels of liquid assets, which means they can meet redemption requests on demand. The amount of liquid assets will vary from fund to fund and over time, depending on market conditions. MMFs usually size liquidity levels based on a combination of minimum regulatory standards, investor considerations and current market conditions. The latter two factors mean MMFs will usually have levels of weekly assets well above minimum regulatory standards.
MMFs usually think about liquidity across four axes:
- Regulatory liquidity: MMF regulation sets minimum levels of daily liquid assets (DLA) and weekly liquid assets (WLA). These buckets are made up of securities maturing overnight or within one week, and certain “eligible” securities. Eligible securities are specified types that can be sold with minimal price impact in almost any market conditions.
- Maturity ladder: MMF managers maintain detailed breakdowns of upcoming maturities so that they can have a day-by-day forecast of cash inflows. These known cash proceeds can play an important role in meeting planned and unplanned redemption requests.
- Liquidity stress testing: Regulation also sets out stress tests MMFs must run. These include, for example, a simulated 40 per cent outflow. Managers will also run bespoke stress tests, taking into consideration the composition of investors in MMFs they manage.
- Realisable securities: MMFs may sell securities to meet redemptions in some cases. As MMFs invest in high-credit-quality, short-term securities, they can typically sell assets with limited price impact. Nonetheless, for the purposes of regulatory and internal stress tests, managers will factor in haircuts to asset prices in their stress tests. This means managers are highly attuned to the total ability of a MMF to provide liquidity.
In a worst-case scenario, a MMF could suspend redemptions. However, none has done so since 2008, when MMFs were materially different both in terms of regulatory requirements and prevailing investment practices.
Subsequently, regulation has tightened significantly, and MMF management practices have become more conservative. In fact, MMFs have “passed” two recent severe real-life stress tests as we explained in our recent article on sterling money markets.1
MMFs only invest in securities of the highest credit quality. From an external perspective, this means securities or issuers rated F1/A1/P1 or better. These are short-term ratings assigned by major rating agencies to securities with maturities of up to around one year, and roughly equating to long-term ratings of A or better.
From an internal perspective, managers assess all issuers and securities before investing and monitor exposures on an ongoing basis. The analysis is in-depth and sophisticated, involving, in our case, an internal rating scale. Formally speaking, the regulation specifies MMFs should only invest in securities or issuers for which they have a “favourable” credit assessment.
Rating agencies typically complement ratings with “outlooks” and “watches”. The former signify the probable direction of travel for the rating over the medium-to-long-term, while the latter signify a potential near-term risk and, hence, rating change.
These indicators serve as a useful tool in constructing MMF portfolios. In combination with internal credit analysis, this can help funds exit positions before credit risk developments trigger downgrades. Defaults among the highly rated securities and issuers held by MMFs are exceptionally low.
Interest rate and spread risk
Duration – a measure of the sensitivity of the price of a security to interest rate changes – is structurally low in MMFs. This conveys two advantages: first, if there is a sudden, significant move in interest rates, it will not significantly affect the value of the MMF. Second, as securities mature quickly in MMFs, they can reinvest quickly at new, higher interest rates. This will increase the yield the MMF can provide to investors.
The two key risk metrics are:
- Weighted average maturity (WAM) or sensitivity to interest-rate risk. WAM is based on time (days) to the next interest rate reset date and is capped at 60 days by regulation. MMFs can increase or decrease WAM (within the 60-day cap) based on their outlook for interest rates.
- Weighted average life (WAL) or sensitivity to spread risk (the risk that security prices change). WAL is based on time to maturity and will therefore always be equal to or longer than WAM. WAL is capped at 120 days by regulation and, again, MMFs can adjust their WAL positioning up to the 120-day limit.
MMFs are often rated by major international rating agencies. The rating process involves a thorough assessment of the investment manager and ongoing close monitoring of the MMF. The manager assessment tests all areas of the investment process – from credit research through to portfolio management, risk management and investor interactions.
Rating downgrades are extremely rare, reflecting the conservatism in MMF portfolio positioning
The ongoing monitoring is based on high-frequency portfolio holdings level reports, providing the agencies with a granular and near-real-time view of MMFs’ risk positioning. If the agency notices a deterioration in a rating metric, it will typically contact the manager of the MMF promptly to understand how and when they intend to rectify it. If the response is unsatisfactory and/or adverse developments continue, the agency may downgrade or place a fund on negative rating watch. Rating downgrades are extremely rare, reflecting the conservatism in MMF portfolio positioning.
Most MMFs are rated AAA. While exact rating agency definitions differ, they all incorporate a view on the stability of capital, while some also provide a view on liquidity. The metrics analysed by agencies are close to, although not necessarily aligned with, MMF regulation. In fact, agency guidelines are stricter than regulation in some areas, notably in terms of minimum credit quality.
Investors can therefore take comfort from the presence of ratings as a risk control tool and for the ongoing monitoring the agencies provide.
MMFs publish annualised yields daily. Yields are typically close to prevailing cash rates, such as overnight SONIA (Sterling Overnight Index Average). When rates rise, MMFs typically reset to the new rate quickly. Conversely, when rates fall, MMFs can use their ability to buy longer-dated securities to slow down the impact of the rate cut. In a stable rate environment, MMFs can use their risk budget to optimise returns relative to cash rates.
MMF yields reset quickly to rate rises
MMFs respond to rate rises quickly. We estimate it takes about 20 days for MMF yields to reset to a 25-basis point rate rise and correspondingly longer for rises of greater magnitude. Additional “in-period” rate rises will also influence the speed of re-set. The result is that MMF investors will benefit from new, higher yields in only a matter of weeks after central bank rate rises.2
Rates available on bank deposits can materially lag central bank rates
In contrast, commercial bank deposit rates move slower. The average new overnight deposit rate for European non-financial corporates was just 15 basis points (bps) as of end-November 2022, despite the ECB deposit rate being 1.50 per cent at the time. The ECB raised the deposit rate to zero in July 2022, but around 150 days later (in late December), the average euro zone commercial bank overnight deposit rate for new agreements was still just 19bps, implying a considerably slower adjustment rate than that of MMFs.
Clearly, some investors will have been able to access better rates than 15bps, but the fact remains rates available on bank deposits can materially lag central bank rates.
On the way down, MMFs can use their ability to “term-out” their portfolios to delay the impact of falling yields.
Figure 3: Time taken for MMF yields to catch-up with ECB deposit rate
|ECB deposit rate adjustment date||Rate movement (bp)||Days for MMF yields to catch up|
Source: Aviva Investors, Bloomberg, iMoneyNet, February 2023
ESG in MMFs
Increasingly, MMFs are integrating environmental, social and governance (ESG) considerations into their investment processes. In fact, a majority of Low Volatility Net Asset Value (LVNAV) MMFs were designated Article 8 under the European Sustainable Finance Disclosure Regulation (SFDR) by the end of 2022.
Figure 4: SFDR classification of LVNAV MMFs
Note: AUM as of December 31, 2022.
Source: Lipper for Investment Management. Data as of January 9, 2023
An SFDR Article 8 “investment product” is one that promotes environmental or social characteristics. The approach to doing so may vary across different MMF providers, so it is important to dig into the details to understand the exact approach to implementing ESG.
Since January 2023, all providers of Article 8 products have had to publish standard information on their approach, in their Pre-Contractual Disclosures (PCDs). PCDs for our liquidity strategies can be found here.3
MMFs fall under European MMF regulation, formally known as “Regulation (EU) 2017/1131 of the European Parliament and of the Council of 14 June 2017 on money market funds”.4 The regulation is currently being reviewed – we discussed potential changes in our recent article on European money market fund reform.5
Four types of MMF
The regulation defines four MMF variants, with each allowed to take incrementally higher risk (albeit still low risk in aggregate). The first three types detailed in Figure 5 classify as “short-term” MMFs, while the “standard” type categorises separately.
Figure 5: The MMF variants
Source: Aviva Investors, February 2023
Cash equivalence is a motivating factor for many investors in MMFs.
Unfortunately, rules defining cash equivalence vary across jurisdictions. In the US, all MMFs are defined as cash equivalent, including stable-value and variable-value MMFs. Similarly, in France, all MMFs, including “standard” VNAVs, are classified as cash equivalent. In other jurisdictions, this level of clarity is absent.
Many investors – and their auditors – will limit cash equivalence to short-term MMFs only, reflecting that the maturity limitations and characteristics of short-term MMFs align with the definition of cash under IAS 7.
There are granular portfolio rules covering MMFs. On top of the MMF-specific rules, most MMFs are also covered by the overarching mutual fund framework (most MMFs are “Undertakings in Collective Investment in Transferable Securities” or UCITS). Combined with the rating agency requirements, the complexity of managing MMFs is high.
Figure 6: Regulatory risk limits
|LVNAV||Short-term VNAV||Standard VNAV|
|Credit quality ||“Favourable assessment”|
|WAM (days)||60||60||60||180 (six months)|
|WAL (days)||120||120||120||360 (12 months)|
|Maximum maturity (days)||397||397||397||397 or two years where the next rate reset is within 397 days|
|DLA (per cent)||10%||10%||7.5%||7.5%|
|WLA (per cent)||30%||30%||15%||15%|
Note: *Stable in most market circumstances – see The Nav collar test.
This table is not exhaustive – there are many additional rules covering, for example, diversification and some of the rules specified above have sub-components (e.g., liquidity). MMFs typically operate with buffers relative to the regulatory limits, providing additional protection to investors.
LVNAVs (and to some extent, PD CNAVs) have certain important features:
Net asset value (NAV)
LVNAVs and PD CNAVs can transact at stable values. Specifically, this means a NAV expressed at two decimal places. VNAV MMFs must price to four decimal points. LVNAVs and PD CNAVs can also use amortised cost pricing for the shortest-dated securities (under 75 days) while all pricing in VNAVs must be mark-to-market (MTM). In practical terms, LVNAVs must mark all securities to market anyway and test for variance against the amortised cost.
If an LVNAV’s WLA assets fall below certain thresholds, the MMF’s governing body must take one of several actions outlined in The WLA test. One outcome is suspension of redemptions; however, there are good reasons why a fund’s governing body would not choose this unless faced with a truly extreme situation. The link between WLA and redemption suspensions features prominently in the ongoing review of the MMF regulation globally.
The WLA test
If a VNAV's WLA falls below 30 per cent and the LVNAV has a simultaneous net outflow of more than ten per cent, the MMF’s governing body must decide between one of these options:
- Doing nothing
- Applying a liquidity fee commensurate with the cost of providing liquidity
- Pro-rata redemptions over a few days
- Suspend redemptions temporarily.
At this stage, the governing body has significant discretion.
If the WLA falls below ten per cent, the fund’s board must either:
- Apply a liquidity fee commensurate with the cost of providing liquidity
- Pro-rata redemptions over a few days
- Suspend redemptions temporarily.
At this stage, the governing body still retains some discretion – over the measure to apply and size of any liquidity fee. However, it is required to apply at least one measure.
If the LVNAV suspends redemptions for more than 15 days in any 90-day period, it must convert to a VNAV.
MMF history and distribution
The history of MMFs dates back to the 1970s in the US, where they were created as an alternative to bank deposits. The first MMFs appeared in Europe in the early 1980s. Since then, MMFs have spread around the world. Total assets worldwide exceeded US$2 trillion at the end of Q3 in 2022.
Three jurisdictions dominate: the US, China, and Europe, collectively accounted for almost 90 percent of total global MMF assets at the end of Q3 last year, according to Lipper for Investment Management data. In Europe, MMF assets are concentrated in Ireland, Luxembourg and France. French MMFs are distributed primarily domestically in France. Irish and Luxembourg MMFs are widely distributed across Europe and into other locations, such as Singapore.
Within Europe, MMFs classify further under the European regulatory framework. The largest MMF type, by assets, is the “standard” MMF, predominantly domiciled in France and denominated in euros. The LVNAV fund type dominates in Ireland and Luxembourg and is denominated in multiple currencies, with US dollars the largest segment. Assets are significant across LVNAVs by currency.
- MMFs offer diversified high-credit-quality exposure and competitive yields that reset quickly to prevailing overnight rates. This combination means they play a core role in cash optimisation.
- While not risk free, their risk profile is low, owing to the types of security MMFs buy, the level of diversification in portfolios and active management of risks.
- ESG considerations are playing an increasingly important role in the management of MMFs, particularly in the European market.
- Aviva Investors operates a range of MMFs in multiple currencies, with scale offerings to suit all cash investors’ needs.