Money Market funds, Floating NAVs & Credit Events

Money Market funds, Floating NAVs & Credit Events

I was talking with two new friends of mine today regarding money market funds.  Surprising me, on asked whether the proposal that I made to the SEC covered only credit events, or whether it covered interest rate risk as well.

I all too easily commented that movements of short rates don’t happen fast enough to affect a money market fund, causing the shadow NAV to break the buck (i.e. drop below $0.995) — that we would need a banana republic scenario for that to happen.

But it bugged me that I did not know that for sure, so I pondered on how I could answer the question.  Then it hit me.  Use commercial paper rates to estimate a net asset value for a hypothetical money market fund with an average maturity of 45 days.  Using data from FRED, it took me roughly one hour to complete the analysis, and what I learned surprised me.  (Note: being surprised is good, because it means real learning is taking place.)

From 1971 to the present, money market funds without defaulted securities would have a shadow NAV below 0.995 15.4% of the time.  Here’s a histogram that details the shadow NAV versus par.

Thus I would modify my recommendation to my friends, and say that so long as there are no defaults, ignore the discounts to par.  If there is a default, then follow my recommendations, because that loss is certain.

Looking at the history, there are some ugly periods.  Let me describe them.

In late January 0f 2009, liquidity dried up for short-term unsecured bank debt the NAV of my hypothetical MMF got down to 96 cents on the dollar.  It was back to par in one week.  That could just be bad data.

In early December 1980, when I was celebrating my 20th birthday, and having my first truly “happy birthday” in three years, the shadow NAV got to 97% of par, but three weeks later was back at par.

I am embarrassed regarding my assertions.  Money market funds vary far more than I imagined, and I am only dealing with averages here.

But I think there is a rule here for intervention: do not intervene over interest rate moves.  Money market funds are resilient enough that credit events should only happen when a security has defaulted.

That said, if one wanted to run my rule when money market funds’ shadow NAV dropped below 0.995, it would not matter much to holders.  The loss of units would be recouped within 60 days or so.

Without a default, there is no reason to impose a credit event on money market funds, because in all past cases, the situation will right itself with time.

I do not claim omniscience here — things could be different in the future, particularly with low rates.  But absent defaults, money market funds have generally returned to par amid otherwise tough situations.

By David Merkel, CFA of alephblog



About the Author

David Merkel
David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.