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SEBI has specified many categories of debt mutual funds. In this post, let’s talk about money market funds.
I will address common questions about money market mutual funds in this post. Where do Money market funds invest? What are money market funds? Who should invest in money market funds? How much return you should expect? What you should keep in mind while selecting a money market fund?
What are Money Market Funds? Where do Money Market Funds invest?
As per SEBI rules, money market funds can invest in money market instruments maturing in up to 1 year (having an unexpired maturity of 1 year).
Clearly, this limits the level of interest rate risk a money market fund can take. Since the securities will mature in up to 1 year, the portfolio duration and the interest rate sensitivity (risk) of the portfolio will also be low.
Call Money/Notice Money/Term money: Money is lent on an overnight basis (call money) or for a period of 2 to 14 days (notice money) or for a period between 15 days and 1 year (term money). As I understand, only banks and primary dealers can participate in call money market.
Collateralized Borrowing and Lending Obligation (CBLO): This is a secured money market instrument. The money is borrowed for up to 91 days against the collateral of eligible securities. Eligible securities are Government bonds including treasury bills.
Repo/Reverse Repo: This is regulated by the Reserve Bank of India. Repo is borrowing funds by selling securities with an agreement to purchase them back at a mutually agreed future date at a mutually agreed future price. Reverse repo is the exact reverse of repo. Money market Mutual funds can invest/transact in Reverse Repo.
Treasury Bills: are issued by the Government of India in tenures of 91 days, 182 days and 364 days. Treasury bills are zero-coupon securities (do not pay interest) and are issued at discount to face value. The discount on the face value constitutes the return for the lender/investor. No risk of default.
Certificate of Deposit (CDs): Can Be issued by banks and permitted financial institutions. The tenure for CDs issued by bank ranges from 7 days to 1 year. The tenure for CDs issued by other financial institutions ranges from 1 year to 3 year.
Non-convertible debentures of original maturity or initial maturity up to 1 year: Can up issued with maturity ranging from 90 days to 1 year. Minimum credit rating of A2 for the issue (A1 is the best. A4 and D are the worst).
You can also check the month end portfolios of a few money market funds at respective AMC websites to get an idea of the holdings.
Basis the kind of investments a money market fund can make (or the companies that can access money markets), I expect credit quality of the underlying portfolio to be quite good. At the same time, we must take these credit ratings with a pinch of salt. Credit rating agencies let investors on a reasonably frequently basis.
How much return you should expect from Money market funds?
If nothing untoward happens in the underlying portfolio, you should expect better returns that a liquid fund. On a pre-tax basis, expect returns in line with a short-term bank fixed deposits (6 month or 1 month).
The element of credit risk and interest rate risk in the portfolio can also impact returns (and volatility in NAV.
Do note that money market funds provide market linked returns. Therefore, interest rate movements, liquidity problems, credit defaults, change in credit spreads or any other market events can result in NAV fluctuations.
How are Money Market Mutual Funds taxed?
Money market funds are variants of debt mutual funds. Therefore, the tax treatment is the same as for a debt mutual fund.
Short term capital gains (holding period up to 3 years) are taxed at your marginal tax rate. Long Term Capital Gains (holding period > 3 years) are taxed at 20% after indexation.
Any dividends from such funds are exempt in the hands of the investor. However, a Dividend Distribution Tax of 25% is deducted before the dividend is paid out to the investor. Since the DDT is charged on gross basis, the effective tax hit is ~28%.
For more of capital gains tax on the sale of mutual funds and taxation of dividend, refer to this post.
Who can invest in a Money Market Fund?
SEBI has specified different debt mutual fund categories limiting either the interest rate risk or credit risk for each of the categories (I am leaving out gilt funds). As I have mentioned many times earlier, I do not prefer to take interest rate risk. I prefer short duration debt funds even for my long-term goals (for the debt portion). However, for the fund categories that carry low-interest rate risk, SEBI does not limit the level of credit risk these funds can take.
For instance, some of the ultra-short or low duration debt funds with the best star ratings invest in low-quality debt. Lower quality debt offers a higher return (with higher risk). Higher returns help such funds maintain star status. Now, for an investor looking for a fund (outside of liquid and overnight funds) with low interest rate risk, this is an issue. By the way, there is nothing wrong in taking credit risk so long as you are aware of the risks involved.
Among all the confusion, Money market funds may be a slight exception.
Money market funds have an explicit limitation on interest rate risk (portfolio duration) and an implicit limitation on the credit quality of the portfolio (believe only good companies will be able to access money markets). Therefore, for investors looking to invest in funds with low-interest rate and credit risk, money market funds may be a good choice.
However, as we have seen one of the companies with best-rated debt default on its debt (IL&FS defaulted on its commercial paper), even money market funds can face issues. And on paper, RBI money market rules still allow fund houses to pick up not so good debt (for instance, A3 for commercial paper). Therefore, while selecting debt funds including money market funds, it is still a good idea to go through this checklist on selecting debt funds.
Could you please explain the difference between the money market funds and ultra short term funds?
Ultra-short duration funds have to keep duration upto 6 months. Money market can take that up to 1 year.
So, technically, a money market fund can higher interest rate risk.
Ultra short-term debt funds don’t necessarily have to limit themselves to money market instruments. No limitation on the amount of credit risk either.
The two categories will have a similar return profile.