Waning interest dogs money market funds

By Scot Blythe | April 8, 2009 | Last updated on April 8, 2009
4 min read

Money market funds have been one of the great success stories of cash management. Started in the early 1970s as a way to earn higher interest rates than regulated bank deposits in the U.S., they brought in burgeoning assets from conservative investors and eventually from corporate treasurers looking to get a yield.

But the Great Recession stripped away the veil of certainty surrounding money market funds as a number of them “broke the buck.” Breaking the buck means, in the U.S., a net asset value lower than $1 in the U.S. (In Canada, it’s lower than $10). Normally, NAV is fixed, and interest is either paid out or reinvested in new units.

Breaking the buck — once an almost unthinkable event, — threatened a massive run on the banks in September, and was a major reason for the U.S. Treasury Department’s massive intervention in backing up financial markets — for the most part because many money market funds held commercial paper from the now bankrupt Lehman Brothers.

The major constituents of a money market fund are: commercial paper used by firms to finance their short term payments such as payroll and accounts payable; bankers acceptances often used by firms to finance payments to overseas suppliers; and auctioned T-bills. They are also a fundamental source of liquidity for the economy.

While Canadian funds did not face the same dire circumstances as some of their U.S. counterparts, the slow unwinding of the non-bank asset-backed commercial paper market made for some travails, with fund companies stepping in to buttress the NAV of their money market funds by assuming the non-bank ABCP at the corporate level. There were 23 fund complexes involved, and National Bank, for one, had 40% of its assets in non-bank ABCP.

It’s been a rough ride for funds esteemed as the safest of havens.

Not coincidently, the challenge that money market funds face is the same one that had pushed some to buy ABCP: the paltry yield on T-bills. Back in the 2000-2002 bear market, the U.S. Federal Reserve Board pushed short-term interest rates to 1% to stave off a deflationary episode of Japanese proportions. At the time, many observers wondered how fund companies would make a buck, given fixed management fees that ate up much of the yield money market funds earned.

Is it déjà-vu all over again?

One thing is different; while short-term interest rates are at unprecedented lows, banks are still offering premium savings accounts with much higher coupons. Toronto consultancy Investor Economics, in its February edition of Investor Economics Insight, reports a three-month yield of 0.62% on money market funds, versus bank rates of 3.5%.

It’s important to understand that money market funds are buying various instruments at their current, short-term yield. These instruments have a 90-day maturity. By contrast, premium savings accounts, like any savings accounts, are means by which banks raise money to fund longer-term obligations, such as mortgages. And if mortgage rates haven’t followed in lockstep with the Bank of Canada’s interest rate cuts, that is precisely the reason. Mortgages are not funded off short-term T-bills, but longer-term bonds, with their risks, priced off the yield of a five-year bond.

Despite their popularity, money market funds actually attract a diminishing proportion of Canadians safe assets. From one perspective, there is a trillion dollars on the sidelines today, the money people sock aside for their immediate needs. Over half of that money is in GICs, 21% in savings accounts and only 6% in money market funds. Those amounts have been relatively stable of the past decade, with one exception: premium savings accounts are drawing money from all categories. It’s also useful to know that this category constitutes 46% of all household financial wealth.

To some degree, premium savings accounts undercut the growth potential of money market funds. They were aggressively marketed, even in the advisor channel, and what’s more, sported a Canadian Deposit Insurance Corporation guarantee.

To be sure, more money is flowing into money market funds, with a 34% increase last year. Largely, the increase is being captured by bank funds, and premium money market funds managed by the banks account for a third of assets.

The size of the Canadian money market fund universe stands in marked contrast to its U.S. counterpart. South of the border, money market funds control 40% of fund assets. In Canada, it’s 15%. But then, money market funds, in Canada, seem to represent less a safe interest play and more a safe hiding place when equity markets are in decline, generally during RRSP season.

That, according to Investor Economics, suggests that the primary use of conventional money market funds is, in fact, a convenient parking lot rather than a substitute for a bank savings account.

That’s a fundamental characteristic for advisors to consider. Money market funds may not be the best way to hold cash; but they may be a springboard for future equity investments.

That’s probably a good thing, since money market yields are at decade lows.

In fact, those yields are now more or less equal to MERs. That may force some companies to chop MERs, and in particular, trailer commissions.

On the other hand, after the non-bank ABCP fiasco forced Dundee’s hand, its premium savings account, now managed by ScotiaBank, has grown at almost twice the rate of other premium savings accounts.

So there’s certainly an advisor interest in high-yield savings accounts, even those that are ultimately managed by the banks.


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