Bank Worries, Market Fears, And The Investment Everyone’s Using To Beat Them Both

Money market funds (MMFs) have been enjoying some newfound popularity – and record inflows – lately. With the banking mini-crisis and recession fears still hanging over markets, investors have been on the hunt for safe assets that also offer attractive returns. MMFs, handily, fit the bill. So let's take a look at what they are, what the new surge of interest might mean for markets and the economy, and why you might want to include them in your portfolio.

What are money market funds?

They’re a type of investment fund that invests in low-risk, highly liquid, short-term debt securities like Treasury bills, commercial paper, certificates of deposit, repurchase agreements, and more. They’re generally seen as a safe place to park cash that’s waiting to be invested or that’ll be needed in the near future.

These funds have historically maintained a $1-a-share value, preserving the value of investors’ principal, with interest paid in dividends. MMFs are typically managed by financial institutions, like mutual fund companies or investment banks, and are offered to individual and institutional investors – both of whom have been pouring record amounts into these funds lately.

How popular have MMFs become?

About $350 billion flowed into US MMFs in the four weeks ending April 5, pushing the total invested in the funds to a record $5.25 trillion. And Barclays thinks we've only just set sail: the investment bank sees another $1.5 trillion flowing into the funds over the next year.

Huge sums of money have been flowing into MMFs over the past few weeks, pushing total assets to new record highs. Source: Bloomberg.

Why are these funds booming now?

Two reasons. First, the collapse of three regional US banks this year and the rescue deal for Credit Suisse have sparked concerns about the safety of bank deposits, pushing savers and businesses to look for alternative havens to park their cash. This is especially the case among large depositors who hold more than the $250,000 limit insured by the Federal Deposit Insurance Corporation (FDIC). Second, the yields available on MMFs are now higher than they’ve been in years because they rise with interest rates. In contrast, banks have barely shared the Fed’s higher interest rates with their depositors.

That second point is particularly important. See, over the past two decades, around 86% of changes in the Fed’s interest rates flowed through to retail MMFs, compared with just 26% for retail cash deposits at banks. That’s more than three times the amount. Just look at today’s prevailing level of interest rates and MMF yields. For example, the yield offered on the biggest retail MMF, the Fidelity Government Money Market Fund, is around 4.48% as of the time of writing. Compare that with a 0.06% national average on interest checking accounts and 0.39% on savings accounts, according to April data from the FDIC.

Compared to retail cash deposits, MMFs have historically passed on more than three times the changes in central bank interest rates. Source: Federal Reserve Bank of New York.

Because MMFs are more nimble at passing on interest rate changes, there’s even more room for them to keep ballooning in size as rates head higher. After all, traders are still betting on a 0.25 percentage point rate hike at the Fed’s meeting in May.

What are the implications of MMFs’ popularity for banks and the wider economy?

That depends, but generally, they’re not good. See, banks take in money in the form of customer deposits and then lend it out again as loans. These deposits are a bank’s main source of funds – and typically the cheapest. So if MMFs remain a more appealing option for savers than deposit accounts, banks may be forced to rely on costlier sources of funding, reduce their lending activity, or some combination of both. In recent years, small and midsize banks have been instrumental in driving total loan growth, so any factors that dial back their lending could potentially lead to a more significant economic slowdown than what the Fed is hoping to engineer.

We’re already seeing evidence of this, with data out earlier this month showing US bank lending contracted by $105 billion in the last two weeks of March. That was the biggest drop since the Fed began tracking the data back in 1973. The more than $45 billion decrease in the last week of March alone was primarily due to a big drop in loans by small banks.

US bank lending contracted by a record $105 billion in the last two weeks of March. Source: Bloomberg.

Why should you care?

Outside of bear markets, holding cash during the era of zero interest rates was bound to be a drag on investors’ returns. But now that interest rates have shot up, cash is starting to look like a very attractive asset class, and one that plays several important roles in a portfolio.

First, cash currently offers an attractive, low-risk source of return. If parked in MMFs, you can expect yields of around 4.5%. Second, cash offers immediate liquidity, allowing you to quickly access funds to make changes to your portfolio, cover unexpected expenses, meet short-term financial obligations, and more. Third, adding cash to a portfolio makes it more diversified, reducing total volatility and improving risk-adjusted returns. That’s because cash has a very low or negative correlation with most other asset classes. Fourth, cash can cushion a portfolio against potential losses, especially during times of market uncertainty. Finally, holding cash allows you to capitalize on attractive investment opportunities as they emerge, potentially boosting long-term returns.

Cash held as deposits reaps all those benefits except the first one. That is, you can still expect very poor returns on your cash if you keep it parked at a bank, which many savers do out of inertia or complacency. Recall that the national average interest rate paid on savings accounts is 0.39%, but you can earn around 4.5% via MMFs.

So how can you buy MMFs?

The go-tos here are brokerage or mutual fund company websites (e.g. Vanguard, Fidelity, Hargreaves Lansdown, and so on), the same places you’d buy any other equity or bond fund. As always, be sure to pay attention to the fund’s fees: among the big retail fund providers, these range from 0.09% at Vanguard to 0.42% at Fidelity. The latter’s MMF has a yield of 4.48%, so its 0.42% fee reduces investors’ returns by almost 10%. In contrast, Vanguard’s fee on its MMF relative to its yield is about 2%. When in doubt about which MMF to choose, I’d personally go with the cheapest one.

What are the risks – and how do you minimize them?

There are two key risks. First, unlike bank deposits, MMFs are not insured by the FDIC, so there’s no guarantee that you won’t lose money. But having said that, instances of “breaking the buck” – that is, having an MMF’s net asset value sink below $1 – are very rare, and usually only happen to funds that invest in commercial paper (unsecured, short-term debt instruments issued by corporations). To minimize that risk for your portfolio, you could choose to buy MMFs that invest only in government-issued securities.

Second, MMFs’ high sensitivity to interest rates means their yields will fall quickly once the Fed starts cutting rates. In that environment, you might want to consider moving some cash out of MMFs and into funds that hold short- or medium-term government bonds, which should see their values increase as interest rates drift lower. You can do that with the iShares 1-3 Year Treasury Bond ETF (ticker: SHY; expense ratio: 0.15%) or the iShares 7-10 Year Treasury Bond ETF (IEF; 0.15%).