There is far more to the money markets than is suggested by their reputation as a holding station for cash. The asset class can offer flexibility, diversification, shelter from market volatility and, in an environment of elevated interest rates, they can deliver compelling yield.
In this article, we outline what the money markets are, how to access them and why investors with a short investment horizon should consider using them as a means of making the most of their cash.
Money market funds are a key beneficiary of the current economic landscape in which interest rates are likely to remain elevated for longer. Continued investor caution and stress in the banking sector is bringing systemic liquidity risks to the fore and reinforcing the need to diversify portfolio exposure. For institutions, money market funds can provide a low-cost, low-risk way to earn a return on their cash.
Understanding the money markets
The money markets are a platform upon which short-term, fixed income securities – typically with maturities of one year or less – are traded between issuers and investors. Issuers in the sector tend to be governments, banks and other large institutions that may use the markets as a source of short-term cash flow. Lenders are typically investors with a short investment horizon willing to commit funds, for a modest return. Instruments traded on the money markets may include government debt, certificates of deposit, commercial paper, repurchase agreements and other short-term debt securities.
Accessing the money markets via mutual funds
A money market fund is a professionally managed, diversified investment vehicle which investors can use to meet short-term cash-management needs or as an investment alternative to the volatility seen in stock or longer-term bond investments. They are typically highly liquid, high-quality mutual funds with the primary investment objective of current income, consistent with liquidity and stability of principal. They offer investors easy access to their cash and the potential for a market rate of income through investments in high-quality short-term debt securities.
How are money market funds used?
Investors can use money market funds to manage short-term cash needs (i.e. to keep some cash liquid for emergencies or near-term purchases) or as an allocation during times of volatility in the stock or longer-term bond markets.
Money market funds are also often used as part of an asset allocation strategy to add some stability to an overall investment portfolio. Such vehicles are highly suitable for institutional investors that:
- Have a short investment horizon
- Have a low tolerance for volatility, or want to offset volatility in other portions of their investment portfolio
- Need a highly liquid investment option.
Benefits of money market funds
Money market investments are sometimes referred to as ‘cash’, but there are significant differences between the two. A money market fund – unlike cash held in a bank savings account – is an investment that carries associated risks. While money market funds are considered among the safest asset classes on the investment spectrum, they are, however, exposed to changes in interest rates, credit and liquidity conditions in particular. However, their ability to deliver above-base rate returns distinguish them from cash, while their flexibility sets them apart from other fixed income and equity investments.
The key benefits of investing include:
Liquidity
Money market funds are typically highly liquid on account of their exposure to securities – such as government bonds – that can be easily converted to cash. Mutual fund investors may further benefit from pooled liquidity that can often provide same day or next day access to invested funds. This ability to redeem one’s investment at short notice, while generating a modest level of income, make money market funds an effective way for companies and other organisations to make the most of available cash.
Most money market funds are mandated by regional regulations to hold sufficient liquidity to meet foreseeable redemption demands. Typically, they are obligated to allocate a minimum of 10% of the portfolio to assets offering daily liquidity and at least 30% to assets that can be liquidated within a week.
Yield
An actively managed money market fund allows managers to react to market changes, raising the potential to deliver enhanced yield. With interest rates projected to remain high over the medium term, money market funds are attracting significant inflows from institutions looking to lock-in yield in advance of future interest rate cuts. The funds’ ability to preserve capital, offer diversification, and generate yield make them a valuable addition to a diversified investment portfolio.
Capital preservation
Stability of principal is a key objective of money market funds. Because of the strict requirements for investment quality, short investment maturities within a highly diversified portfolio, they have historically provided strong preservation of principal to investors.
This is typically achieved by investing in securities that are lower risk than the wider market, such as certificates of deposit, treasury bills and short-term commercial paper. The brief maturity periods of such securities may mitigate the fund’s sensitivity to interest rate fluctuations. Additionally, as the wholesale money markets are often limited to government and large institutions, investors can benefit from some of the highest quality, short-term debt opportunities available.
Diversification
Within a portfolio of risk assets, maintaining exposure to a money market fund can act as an effective diversifier on account of their lower volatility and risk profile. As money market funds aggregate assets from numerous investors and generally invest across a broad spectrum of holdings, they afford investors access to a diversified portfolio of securities with a lower initial investment threshold.
Overall, money market funds are not just investments for the short term. They can provide liquidity or a lower-risk option within a diverse investment portfolio.
For more information on Federated Hermes’ liquidity solutions please click here.
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