By Ryan DeCaro, Associate Investment Strategist

October 24, 2011

When the average investor thinks about money market funds, the common notion is that they are extremely safe and invested primarily in U.S Treasuries. This perception of safety within the $3 trillion market may not be as accurate as one would imagine. A number of money market funds attempt to enhance returns by holding a large amount of their assets in short-term foreign paper. According to a Bloomberg Report, the ten largest U.S. prime money market funds hold 42% of their assets in European banks.  With the typical money market fund yielding around one basis point, we believe that it is foolish for an investor to take on this additional risk without any financial benefit. Under normal circumstances, the holding of high quality European bank debt would not be of much concern. Additionally, Standard & Poor’s estimates that 80% of European bank holdings is limited to three months or less and 95% to six months or less, so they are very short-term in nature.  Unfortunately, the fiscal problems in Europe have created undue risk for these safe investments no matter the length of the holding.

The fiscal problems in Europe that have come to light over the past few years are very troublesome. With the likelihood of default in the peripheral countries, such as Greece increasing, investors should be cautious of risk they are taking in their cash accounts. The Investment Company Institute stated that, “U.S. money market funds have no direct exposure to Greek sovereign debt, and they have managed and continue to manage any indirect exposure.”  This indirect exposure though is very important. The indirect exposure comes from the concentrated holdings that these money market funds hold in European banks. If Greece were to default, the holders of their debt would be impaired. The possibility of a fund breaking the buck if Greece were to default is much more real than it was two years ago and the investor should receive some level of compensation for taking this risk. Unfortunately, this is not the case as many money market funds are yielding little more than one basis point. Regulators point to Greece as a Black Swan and the likelihood of an event dramatically impacting money market fund holdings as remote, but after the events of 2008 we can see that even the most remote events have the potential to come to fruition. Case in point is the Reserve Prime Fund which broke the buck in 2008 after one of its largest holdings, Lehman Brothers, failed. The Prime Reserve Fund’s breaking of the buck triggered a run on other large money funds and forced the Fed to temporarily insure the holdings of those portfolios. This insurance has gone away and the only solace an investor has is that they are protected for up to $250,000 by the FDIC.

The chase for yield has hit an extreme level as money market fund managers find themselves limited in the types of securities they can buy. Issuance of domestic commercial paper has fallen dramatically and managers are looking to invest in anything that will give them some nominal increase in yield over U.S. Treasuries. Unfortunately, the only viable option appears to be in Europe. Managers have found an extra 10 basis points on average in European debt; therefore they have flocked to these investments unbeknownst to their investors.

These funds are mainly invested in the largest countries in Europe that have a great deal of liquidity. These issuances should not default, but there is still potential for a negative impact to the banks and money market funds if they did and investors should know what they are holding. The additional yield advantage that holding this sovereign debt may be acceptable to the money manager, but many investors may desire to move their assets from these funds if they knew what they were holding. A variety of U.S. Treasury money market funds offer the same, or a very similar, yield as funds with sovereign exposure so there may be no real benefit for taking this additional sovereign risk. Some funds have realized that the inherent risk of investing in European banks is sufficient and have started to pull their funds from these banks. In fact, since June there have been billions of dollars moving out of sovereign debt as the issue received more media coverage. Money market funds reduced their exposure to European banks by 8% on a dollar basis as of the end of August from July, and by 27% since the end of May. This drawdown is encouraging, but it barely makes a dent in the $1 trillion of exposure money market funds have to European debt.

The Federal Reserve has also expressed its distain for money market funds investing heavily in European banks. Eric Rosengren, president of the Federal Reserve Bank of Boston, stated that “Given the systemic importance of the money market mutual fund industry, it is critical that one way or another we make the industry less susceptible to credit shocks and liquidity runs.” Mr. Rosengren made mention of a few key funds that have been extremely aggressive in their investments and the need for some regulation to keep these funds in check. There has been talk of creating a meaningful capital buffer and also treating money market funds as ordinary mutual funds by requiring their share prices to reflect the day-to-day market price, rather than a $1 price. Whether the regulation is centered on the repo market or more broadly, it seems like key members of the Federal Reserve are in agreement that some action must take place to preserve the integrity of the money market industry.

Overall, the likelihood of anything catastrophic occurring to these money market funds is very small. The holdings they have are liquid and the countries they represent are, for the most part, stable financially. However, the same could have been said about Lehman Brothers before it collapsed in 2008, so investors should keep an eye on these funds or move their assets into a fund invested solely in U.S. government debt. Investors should be aware of the additional risk they are taking as money managers chase additional yield and the lack of reward they are receiving for taking that risk. It is critical that you know what you are invested in and determine whether the risk relative to the reward is acceptable.