3 Questions: Federated prime money market funds

10-25-2017

“3 Questions” delves into investment approaches used by Federated Investors strategists. This installment features CIO for Global Money Markets Debbie Cunningham.

Q: Could you speak to how prime money market funds fit into a broad strategy of cash management? Investors have many choices for managing cash, decisions that change as their needs change. Liquidity and stability of principal are paramount criteria, but yield matters. The liquidity portfolio of institutions and individuals often include government money market funds due to their relatively safe investments and the convenience of their constant net asset value (NAV) of $1 per share without the potential of gates or fees. But while U.S. government bills, notes or bonds are generally considered risk free, they offer low yield, especially with the Federal Reserve holding rates at historic lows. Here is where prime money funds come in. They traditionally have offered higher yield compared to government money funds, with comparable stability. Prime funds simply target conservative instruments with slightly more risk—short-term bank and corporate paper, government agency securities and repurchase agreements—that tend to return more than Treasuries. So, the role of a prime money fund is to help a cash portfolio increase its return without compromising stability of principal. It is important to remember, that both retail (for individuals) and institutional prime money funds can impose fees and gates on withdrawals in times of stress. Also, while the former maintains a $1 NAV by rounding to the penny, the latter is required to float its NAV to the precision of a basis point, or $1.0000.

Q:  How do prime funds compare to bank deposits? While both offer liquidity and seek to preserve principal, prime money market fund portfolios typically contain variable-rate and short-term instruments. These allow portfolio managers to quickly reinvest assets to capture the growing yields stemming from a rising-rate environment, as we are in now. The market determines the actual rate, usually the London interbank offered rate (Libor), which historically rises in anticipation of a Fed hike. In contrast, banks offer an administered rate, which is slow to respond to changes, generally rising only around half as much (i.e., if market rates increase 100 basis points, bank rates rise on average 50 basis points). Unlike money market funds, bank deposits are FDIC insured and offer fixed rates of return.

Q: What role does prime play in an aging bull market and rising-rate environment? This speaks to liquidity’s other main functions. In addition to facilitating cash-flow needs of investors, a liquid instrument such as a money market fund offers a stable place to store “dry powder” for use when an investment opportunity arises. The potential for increased yield for prime over govie funds makes that strategy more attractive. Also, in a rising-rate environment, the short-term investments of a prime money fund have less interest-rate risk than fixed-income instruments. Lastly, an investor concerned about the end of the current, historically long business cycle, can hedge against market volatility and downturns by turning to money funds. In times of uncertainty, and these days of anxiousness about the length of the record-breaking run of the risk markets, prime money funds may be a good choice.

Thank you, Debbie.