Risks in Money Market Investing

Money market instruments are considered to be very low-risk investments. This is because the money market as an asset class is considered to have a considerably low-risk profile as compared to other asset classes such as equity and debt.

The main reason for the low-risk profile is because money market instruments consist of a large number of high-quality debt instruments issued by strong counterparties. However, it would be naive for any investor to assume that money market investments do not carry any risks.

It is important for an investor to be aware of the various risks which are present in any money market investment. Money market risks can be broadly classified into four categories.

In this article, we will have a closer look at these four risk categories and how they impact money market investments.

1. Reinvestment Risk: Reinvestment risk is the biggest risk that money market investors face on a day-to-day basis.

   Reinvestment risk refers to the risk that investors may not be able to obtain the same yield when they reinvest the funds after their initial investment in money market instrument matures.

   Companies want to keep their funds liquid. Hence, they prefer financial instruments with lower maturity. However, lower maturities mean that the investors will be exposed to reinvestment risks.

   In order to manage the reinvestment risks, the investors need to be aware of the current yield curve as well as how the macroeconomic factors will affect the yield curve in the near future. It is for this reason that investing in money market instruments cannot be considered to be completely straightforward.

   It requires a certain amount of knowledge as well as skill on the part of the investor to successfully predict how interest rates are likely to change in the future.

   It is common for investors to invest in short dates securities when the yield curve is flat. This is because there is no benefit to locking up funds for additional time in these cases. However, when the yield curve is steep, investors tend to lengthen their duration to increase the overall yield of the portfolio.

2. Counterparty Risk: Money market instruments are also exposed to counterparty risk. It is a known fact that money market instruments are generally issued by high-quality counterparties such as banks, financial instruments, and blue-chip corporations. These counterparties borrow large sums of money with the promise to pay back the principal as well as interest-based on an agreed schedule.

   In most cases, these companies pay back the loans as agreed and the entire transaction is uneventful. However, in very rare cases, investors do not receive the agreed-upon cash flow. This is largely because of extreme external events.

   For instance, when the 2008 credit crisis happened, banks that were considered to be financially strong started failing.

   The Lehman collapse led to financial stress across the entire banking sector and a lot of investors who had invested in money market instruments had to take a haircut. Hence, it would be prudent for an investor to prepare for such black swan events and acknowledge that counterparty risks do exist in the money market.

3. Instrument Risk: Instrument risks are similar to counterparty risks explained above. However, they are different in the sense that these risks are caused by the type of instruments being used.

   For instance, in money markets, there are relatively high-risk instruments such as asset-backed commercial paper which are used. In such a case, it is possible that there might be financial stress or turmoil in this particular segment only. It is likely that other money market instruments such as certificates of deposits or treasury bills may remain unaffected but other assets may face duress causing investors to lose money.

4. Liquidity Risk: Liquidity risk is the risk that the investor will not be able to sell off their money market risks at the desired time and without loss of value. High liquidity is considered to be one of the characteristic features of the money market. Hence, it is ironic that money market investments also have liquidity risks. However, this is a reality and investors must prepare for the same.

   Under normal circumstances, money markets offer unparalleled liquidity. However, in times of duress, liquidity may be a challenge.

   Once again, the case of the 2008 credit crisis can be used to explain the point. During this crisis, banks as well as individuals were unable to liquidate their holdings and exit the market. There was a credit freeze for some time when investors were simply not able to find any counterparty. Later, they were able to find a counterparty. However, they had to undertake the transaction at a loss.

   Of late, regulators have also introduced certain rules which have the potential to create liquidity problems.

   For instance, money market funds have the right to impose an exit charge and even temporarily suspend the redemption of funds under certain circumstances. This will obviously exacerbate the liquidity issues. Hence, it is important for investors to be aware that such a situation is likely to arise and be prepared for the same.

The bottom line is that money markets also have significant risks. These risks are negligible under normal circumstances. However, this does not mean that the investors must simply ignore them.