Home/Article/Understanding the returns and risks of money market mutual funds
Understanding the returns and risks of money market mutual funds
19 Jan 2023

Normally money market funds and liquid funds are used interchangeably for mutual fund investors. The idea of money market funds is to restrict the investment portfolio to assets with a very short term maturity profile of less than 91 days. That is the typical profile of a money market fund with a large chunk of its assets deployed in assets with a residual maturity of less than 60 days. By holding assets with maturity of less than 60 days, money market funds can avoid the mark-to market risk that most long-term debt funds run.
So, what are the benefits of money market mutual funds and what are the risks of money market funds? How do money market funds work and for whom is it suitable? Typically, you do not see retail investors putting money in money market funds. It is institutions, corporates and banks who typically park money in money market mutual funds. These funds will invest in instruments like call money, CBLO, repo, reverse repo, commercial paper and certificates of deposit.

What returns to expect from money market funds
Remember that money market funds are extremely liquid and are therefore classified as near-cash instruments. Hence in terms of returns and risk they are comparable to savings bank accounts where one can enter and exit at very short notice. Most money market funds offer same day redemption credit to fund holders. Since they invest in government backed debt of very short maturity, these money market funds are immune to default risk and to interest rate risk too. If one looks at the table below as per CRISIL ranking of money market mutual funds, the average annualized returns on a money market mutual fund is to the tune of 6.5-6.8% in a best case scenario..

Your average savings account pays an interest of around 4% so this is definitely a better option than a savings account since the returns are at least 200-250 basis points higher. In terms of tax treatment, the money market funds may have a slight advantage, especially if you are taxed at the peak rate of tax. So your bank interest will be taxed at 30% peak tax rate whereas the taxation of money market funds will differ based on whether it is a dividend plan or a growth plan.
In case of dividend plan, the dividends are tax-free in the hands of the investors. However, dividends are paid out after deducting DDT at 28.24% and hence there is not much of a tax-related advantage. Secondly, in case of growth plans, the benefit of LTCG is only available in money market funds if it is held for a period of more than 3 years. Otherwise the capital appreciation will be taxed at the peak rate, exactly in the same way as bank deposits.

How are money market fund yields likely to behave going ahead?
There have been speculations that since the RBI is unlikely to cut rates further from here, the yields on money market funds may not go down further from here. That may not actually be the case. Here is why! Yields on money market instruments are not a function of rate signals by the RBI but they are an outcome of the liquidity in the money markets. With abundant liquidity in markets and the RBI keeping the markets liquid, the yields on money market instruments are likely to stay on the lower side. In fact, money market yields have been trending lower for quite some time now and that trend could continue for some more time.

How the money market yields are trending downwards
Normally, the money market yields are at a slight spread over the repo rates. When repo rates were above 8% prior to 2015, most money market funds were yielding between 8.5% to 9% returns. With repo rates down to 6% and abundant liquidity queering the pitch for the spread, the money market yields have fallen by close to 250 basis points in the last few years. This trend is likely to continue and that remains the big risk factor. Of course, the demand for money market funds will continue considering that it is a lot more flexible compared to savings accounts, but that advantage is gradually diminishing. With banks flush with liquidity, one can expect pressure on money market fund yields to continue in the months to come.

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