As the Federal Reserve embarks on an aggressive interest-rate hike program to fight high inflation, some fixed-income specialists anticipate traditional money market funds will provide greater yields than the near-zero rates they have had in recent years.
With rising rates along with other new macroeconomic worries, such as geopolitical instabilities triggered by Russia’s invasion of Ukraine and rising inflation and commodity prices, more institutional investors could be motivated to move deeper into money markets — not just for their yield, but for their low-risk and low-volatility characteristics, said Peter Yi, Chicago-based director of short-duration fixed income and head of taxable credit research for Northern Trust Asset Management.
“The market is pricing in the equivalent of at least eight more rate hikes this year,” Mr. Yi said. “This trend could make money markets more attractive to investors, to help them generate yield while maintaining liquidity and safety.”
Mr. Yi said that a move into money markets would be driven primarily by liquidity considerations and secondarily by “asset allocation views that incorporate diversification and portfolio stability.”
Investors, including institutions, had already started pouring cash into money markets in the spring of 2020 as a result of massive global uncertainties caused by the COVID-19 outbreak, Mr. Yi said. As the safest and most risk-controlled of securities, money markets became more attractive to a broad swath of investors spooked by the unknown effects of the unprecedented global health crisis, he said.
The size of the public money market mutual fund assets universe swelled past $4 trillion in 2020, surpassing the peak of the 2008-2009 global financial crisis, Mr. Yi noted, and now stands at about $4.5 trillion as of April 13.
Mr. Yi explained that the capital markets saw a huge infusion of new debt, especially investment-grade bonds, since the onset of the COVID-19 pandemic. This “put a lot of liquidity on corporate balance sheets that was eventually invested in money market funds, increasing industry assets,” he added.
Of NTAM’s $1.3 trillion in assets under management as of Dec. 31, about $191 billion is parked in U.S.-registered money market funds.
John H. Tobin, New York-based chief investment officer at Dreyfus Cash Investment Strategies, a division of BNY Mellon Investment Management with about $370 billion in assets under management, said that money market funds perform well amid rising rates since they are highly liquid instruments and “capture the rate hikes” very quickly.
Mr. Tobin noted that the Fed’s stance on tightening has significantly changed since December as concerns about persistently high inflation have driven the central bank to seek to push rates at an aggressive pace this year.
Justin Hoogendoorn, Chicago-based head of fixed-income strategy and analytics at Hilltop Securities Inc., a full-service municipal investment bank and registered investment adviser, said money markets should perform “extremely well” in an environment of Fed rate hikes. “Generally, I think that retail flows will grow quicker than institutional demand as the Fed raises rates,” Mr. Hoogendoorn said. “Either way, I would expect the sector to grow.”
He said that as the Fed gets closer to a rate of 1% and above, “we expect interest to grow” in money markets. “With that in mind, we expect money markets to perform excellently this year as other asset classes generally struggle with the wicked combination of inflation, geopolitical risks rising and (economic) growth beginning to moderate.”
Based in Dallas, Hilltop had $22.5 billion of institutional AUM, including money market funds, as of Feb. 28.
Institutional investors already own a large portion of the money market universe.
According to data from the Investment Company Institute, a global association of regulated funds, including mutual funds, assets in money market funds totaled about $4.53 trillion as of April 13. Of that amount, institutional investors held about $3.1 trillion.
Data collected by Pensions & Investments show the defined benefit plans of the 1,000 largest plan sponsors had 1.81% of assets in cash, including money markets, as of Sept. 30, up from 1.36% in 2006.
Among the defined contribution plans in the top 1,000, cash, including money market funds, accounted for 10.97% of assets as of Sept. 30, down from a recent peak of 14.33% as of Sept. 30, 2011, but up from 7.93% as of Sept. 30, 2006.
While some money managers expect institutional interest in money markets to grow as interest rates rise this year, thus far investors are shying away.
According to data from Morningstar Inc., in the first quarter, taxable, tax-free and prime money markets witnessed outflows of about $140 billion, $7 billion and $14.6 billion, respectively.
Among institutional investors, taxable money markets and prime money markets saw outflows of $159 billion and $14 billion, respectively, in the first quarter, while tax-free money markets saw an inflow of $1.3 billion.
In contrast, in the first quarter 2020 amid the onset of the COVID-19 pandemic, among institutional investors, taxable money markets saw inflows of $619 billion, although tax-free money markets and prime money markets endured outflows of $2.4 billion and $110.7 billion, respectively.
Scott Gockowski, New York-based senior manager at asset management consultant Casey Quirk, a Deloitte Consulting LLP business, cautioned that while money markets do tend to perform well during periods of higher interest rates, they do not perform as well when inflation rates exceed interest rates, which would be a “net negative” for money markets. Thus, investors would have to gauge the “relative attractiveness” of money markets compared with other asset classes that perform well in an environment of rising interest rates, including Treasury inflation-protected securities, commodities, real estate and infrastructure.
Christopher Philips, head of Vanguard Institutional Advisory Services, estimated that the rate of inflation would have to return to a “more normalized” annual rate of about 3% before money markets would become attractive to institutional investors.
For short-term liquidity needs, Mr. Philips noted many institutional investors are instead opting to use ultrashort bonds and short-term TIPS.
As of March 31, Vanguard had $357.2 billion in money market funds AUM; however, Vanguard currently only offers retail products.
Among defined contribution plans, money market funds have competition as an investment offering.
Michael J. Francis, president of Francis Investment Counsel LLC, an institutional investment advisory firm based in Brookfield, Wis., said stable value funds, another cash-equivalent asset, are highly popular among DC plans because they are viewed as safe as money markets while historically generating higher yields.
In addition, stable value funds have longer durations than money market funds, which, over time, should continue their yield advantage.
Mr. Francis added that money markets would have to yield about 2.25% before they attract attention from DC plans. “You will not see pressure from plan sponsors to invest in money markets until the yields from money markets exceed the yields provided by stable value funds,” he said.
Money markets have underperformed stable value funds in the past quarter and year, but outpaced conventional fixed-income returns. According to data from Morningstar, the Morningstar U.S. Fund Money Market-Taxable fund category was flat for the quarter and eked out an 0.02% gain for the 12-month period, both ended March 31, while the Hueler Stable Value Pooled Universe rose 0.40% and 1.68%, respectively, over those periods.
Meanwhile, the Morningstar U.S. Fund Intermediate Core Bond and Morningstar U.S. Fund Long-Term Bond categories returned -5.89% and -9.98%, respectively, in the first quarter and -4.43% and -3.40%, respectively, for the 12-month period, all ended March 31.