What are money market funds?



What are money market funds in mutual funds?

Money market funds meaning can be either the debt mutual fund schemes which invest in money market instruments or a specific category of debt funds which can invest in debt and money market instruments maturing within 1 year. In this article we will discuss about, what are money market funds, what instruments these schemes invest in, what is the risk profile of these schemes etc? Let us first discuss what is meant by money market in finance parlance.


What is money market?

When we are discussing what are money market mutual funds or money market instruments, we should understand what money market is. Money market is part of financial markets which deals with very short-term fixed income instruments. Participants in money market are usually banks and other financial institutions, institutional investors, corporates etc. Retail investors can also participate in money market through debt funds. Money market funds meaning debt funds investing primarily in money market instruments, can also invest in debt market instruments.

What are money market funds’ instruments?

Money market instruments mature within a year. They include overnight securities (securities maturing overnight) like Tri-Party Repos, Commercial Papers (CPs), Certificates of Deposit (CDs), Treasury Bills etc. Issuers of money market instruments are Government (Treasury Bills), companies (CPs) and financial institutions (CDs).

What are money market funds’ main characteristics?

  • Very short duration / maturity: The duration of money market instruments can range from one day to one year.
  • Highly liquid: Due to their very short maturities, money market instruments are highly liquid.
  • Moderately low interest rate risk: Interest rate sensitivity of a fixed income security is directly related to its maturity. Longer the maturity, higher is the interest rate risk. Since money market instruments have very short maturities, interest rate risk is relatively low. Shorter the duration of a money market instrument, lower is its interest rate risk.
  • Relatively lower yields: The yield of a fixed income security is directly related to its maturity. Longer the maturity, higher is the yield of a fixed income security. Since money market fund’s instruments have shorter maturity / durations compared to Government Bonds, non-convertible debentures (NCDs), State Development Loans (SDLs) etc., their yields are lower than longer duration securities.

What are money market funds’ risk profiles?

Let us first understand the different types of risks in debt funds. There are two types of risk – interest rate risk and credit risk. Let us first discuss about interest rate risk. Price of debt and money market instruments has an inverse relationship with interest rates. If interest rates go up, prices decrease and vice versa. SEBI requires prices of the securities in the scheme portfolio to be marked to market in the scheme NAV. So if interest rate falls and prices rise, NAV will increase and vice versa. The impact of interest rate changes on price of a debt or money market instrument changes with maturities. Instruments with longer maturities are most sensitive to interest rate changes, while instruments with shorter maturities are less sensitive.

Credit risk of debt or money market instruments refers to the issuers’ failure of meeting their interest and / or principal payment obligations, exposing the investor to potential loss of income and / or capital. If the issuer defaults on interest and principal payments then the price of the instrument will be written down permanently as per SEBI’s regulations for mutual funds and the investor may have to suffer a loss. That is why credit risk is the most damaging risk, as far as debt funds are concerned.

What are money market funds’ interest risk profiles?

Money market instruments have maturity of 1 year or less, and therefore are much lower sensitivity to interest rate changes. In other words, interest rate risk is low to moderately low for money market funds.

What are money market funds’ credit risk profiles?

Credit risk of money market funds depends on the credit quality i.e. credit ratings of the instruments in the schemes’ portfolios. Overnight funds, a type of money market fund investing in overnight instruments, have very low credit risk because these instruments are backed 100% by collateral in form of Government Securities (G-Secs). However, other types of money market funds may have credit risk depending on the credit quality of their portfolios. You should always check the credit risk of a debt fund and invest according to your risk appetite.

What are money market funds’ maturity profiles?

Debt and money market instruments have a fixed maturity date, on which the issuer will repay the face value to the investor. As discussed earlier, money market instruments have maturity profiles ranging from overnight to 1 year. Let us discuss another important concept in debt funds known as Macaulay Duration. Macaulay duration is closely related to instrument’s maturity. In simplistic terms, Macaulay Duration is the weighted average number of years an investor must maintain a position in an instrument until the present value of the instrument’s cash flows equals the amount paid for the instrument. Macaulay duration is directly related to the interest rate sensitivity of a fixed income security. Higher the duration, higher is an instrument’s sensitivity to interest changes. Duration is expressed in months or years. The maximum Macaulay duration of money market funds is 12 months. We will discuss maturity and duration of different types of money market funds later in this article.

What are money market funds’ interest rates?

In India money market instruments are issued at discount to face value (FV). The discount depends on the yield to maturity of the instrument. Yield to Maturity or yield is the expected annualized return from your debt or money market instrument. For money market instruments, yield is essentially the interest rate of the instrument. If the FV of a money market instrument maturing in 12 months is Rs 100 and yield is 5%, the instrument will be issued at a price of Rs 95 i.e. 5% discount of FV of Rs 100. Upon maturity the issuer will pay the face value to the issuer.

Yields depend on the maturity of the instrument. Money market funds will longer maturities or durations will have higher yields (we will discuss more on this later). Yields also depend on credit quality. Instruments with lower rating ratings will offer higher yields to investors. You should take duration and credit risk into consideration and make informed investment decisions.

What are money market funds’ yields compared to other debt funds?

The term structure of interest rates of debt and money market instruments, also known as the yield curve is usually upward sloping implying that instruments with longer maturities will have higher yields. Since money market funds usually have durations of one year or less, their yields will be lower compared to other debt funds with longer durations.

What are money market funds’ tax implications?

Short term capital gains (units held for less than 36 months) are taxed at as per your income tax rate and long term capital gains (units held for more than 36 months) are taxed at 20% after allowing indexation benefits. Dividends paid by money market funds will be added to your income and taxed according to your income tax rate.

What are money market funds’ investment objectives?

The primary investment objective of money market funds is to generate income while ensuring sufficiently high liquidity and relatively low interest rate risk. Money market funds can be used as investment options for parking your funds for a few days, weeks or months. If you want low volatility, you can remain invested for longer tenures. You can get long term capital gains tax advantage for investments over 3 years or longer. They are also suitable for Systematic Transfer Plans (STP) into equity funds in volatile market conditions. When investing in money market funds for STP, you should be mindful of exit loads. You will find the exit loads in the scheme information document.

What are money mutual market funds’ different categories?

Money market funds meaning debt mutual funds which invest in primarily in money markets can be classified into several sub-categories based on SEBI’s mutual funds categorization circular. While all debt mutual funds may invest in money market instruments, following categories of debt mutual funds invest primarily in money market:

  • Overnight Funds: These funds invest in instruments that mature overnight.
  • Liquid Funds: These funds invest in instruments that mature in less than 91 days.
  • Ultra-short Duration Funds: These funds invest in instruments such that the Macaulay Duration of their portfolio is 3 to 6 months.
  • Low Duration Funds: These funds invest in instruments such that the Macaulay Duration of their portfolio is 6 to 12 months.
  • Money Market Funds: These funds invest in instruments with maturities of up to 1 year

When you come across the term money market funds or money market mutual funds, money market funds meaning can either be referring to all the 5 categories mentioned above or just the SEBI category, money market funds. Often the term, money market mutual funds refer to all the five categories while the term money market funds refer just the SEBI category, Money Market Funds, meaning funds which invest in money market instruments with maturities of up to 1 year.

Conclusion

In this article, we have discussed about what is money market fund in mutual fund or what is a money market mutual funds, the characteristics of money market funds, different risk factors, returns characteristics, tax implications and different types of money market funds. Money market funds can be better options for parking your excess funds for short periods compared to your savings bank account. Consult with your financial advisor if you want to know more about, what is a money market mutual fund and which money market mutual funds can be suitable for your investment needs and risk appetites.

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