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