Do Low Rates Encourage Yield Seeking by Money Market Funds?   Liberty Street Economics
Liberty Street Economics

« Did the Dodd-Frank Act End ‘Too Big to Fail’? | Main | The New York Fed DSGE Model Forecast–March 2018 »

March 07, 2018

Do Low Rates Encourage Yield Seeking by Money Market Funds?

LSE_Do Low Rates Encourage Yield Seeking by Money Market Funds?

The term “reach for yield” refers to investors’ tendency to buy riskier assets in hopes of securing higher returns. Do low rates on safe assets encourage such yield-seeking behavior, particularly among U.S. prime money market funds (MMFs)? In a forthcoming paper in the Journal of Financial Economics, I develop a model of MMF competition to understand whether competitive pressure leads these funds to reach for yield in a low-rate environment like the current one. I test the model’s predictions on the 2002-08 period and show that, after controlling for changes in risk premia, declines in risk-free rates actually reduced MMF risk-taking, leading to a “reach for safety.”

Recently, there has been much debate about asset managers reaching for yield in a low risk-free-rate environment. Asset managers are typically compensated based on the volume of assets under management, and since investors positively respond to fund performance, asset managers have an incentive to compete over relative performance to attract investors. The concern—expressed, for instance, in a report from the U.S. Treasury’s Office of Financial Research—is that lower returns on safe assets might exacerbate this risk-taking incentive. U.S. prime MMFs have been seen as exemplifying this reach for yield driven by relative performance competition (as observed, for instance, in this speech by former Fed Governor Jeremy Stein). Both regulators and academics have lately paid close attention to prime MMFs because of their crucial role in the global financial crisis; however, there is a relative lack of theoretical and empirical literature on the topic.

Model Overview
In my paper, I model the MMF industry as an economy in which MMFs with different default costs compete over relative performance to attract investors. The cost of default can be thought of as the cost of "breaking the buck"—that is, an MMF having to reprice its shares below the stable net asset value of $1. The heterogeneity comes from the fact that the reputational damages caused by a fund breaking the buck—for instance, outflows from other funds managed by the same sponsor and losses in that sponsor’s franchise value—are different across fund sponsors, as argued here. When competing against one another, MMFs trade off the expected costs of default against the expected gains of outperforming their competitors (by obtaining higher returns through more risk-taking).

The model yields predictions for how different types of MMFs respond to changes in the risk-free rate and the risk premium.

First, the effects of changes in the risk premium vary according to the magnitude of the fund’s default cost: when the risk premium increases, lower default cost funds take more risk, whereas higher default cost funds take less. This bifurcation arises because higher default cost funds are less sensitive to the increased risk-taking incentives that accompany an increase in the risk premium and are more sensitive to the increase in risk that is typically associated with an increase in the risk premium. Of course, this result implies that the differences in risk-taking across funds increase when the risk premium goes up.

Second, and contrary to the “reach for yield” argument, a lower risk-free rate leads all funds to increase their buffer of safe assets in order to maintain their default probability at the preferred (equilibrium) level. That “reach for safety” effect, however, is stronger for funds with higher default costs, so that the risk-taking differential across funds increases as the risk-free rate decreases. In other words, low default cost funds become even riskier, in relative terms, in a low-rate environment.

I test the model’s predictions by looking at the behavior of institutional prime MMFs from January 2002 to August 2008. I choose this time frame because it includes both a significant surge in the risk premia available to MMFs (August 2007 to August 2008) and a prolonged period of low Treasury rates (January 2003 to July 2004). The chart below shows the one-month Treasury bill rate, a proxy for the risk-free rate available to MMFs, and the average spread between rates on risky securities available to MMFs (that is, certificates of deposits and AA-rated commercial paper) and the three-month Treasury bill rate; this spread index is my proxy for the risk premium available to MMFs.

Do Low Rates Encourage Yield Seeking by Money Market Funds?

In fact, concerns about a reach for yield by MMFs and other financial intermediaries in response to low interest rates first emerged in 2003-04. I focus on institutional prime funds because there is considerable evidence that they face a stronger flow-performance relation than retail ones and are therefore more subject to the risk-taking incentives stoked by competition.

To test the first prediction on bifurcated risk-taking in response to higher risk premia, I divide funds by default costs, measured by the share of prime MMFs in the family’s total mutual fund business. This measure captures the reputational costs that a sponsor will incur if its prime MMFs fail: sponsors with relatively less prime MMF business expect to incur larger costs, in terms of negative spillovers to their other business. Consistent with my model, I find that after a 1 percent increase in the risk premium, MMF risk-taking clearly bifurcates by default costs: funds with default costs above the industry median decrease their net portfolio share of risky assets by 3.8 percentage points, while funds with default costs below the median increase it by 3.1 percentage points. This bifurcation is evident in the chart below: the average net risky investments of the two groups start to diverge dramatically after August 2007, when the risk premium available to MMFs increased sharply in response to the run on asset-backed commercial paper and the collapse of two Bear Stearns subprime hedge funds.

Do Low Rates Encourage Yield Seeking by Money Market Funds?

After controlling for the risk premium, consistent with the model and contrary to reach-for-yield concerns, I estimate that after a 1 percent decrease in the one-month Treasury bill rate, all funds decrease their net risky investment by roughly 25 percentage points.

Secondly, also as predicted by the model, the cross-sectional differences in risky investment increase when either risk premia rise or risk-free rates decline. For instance, a 10-basis point decline in the one-month Treasury bill rate (a little less than one standard deviation for the 2002-08 period) increases the difference in net risky investment between funds in the lowest and highest percentile of default costs by 5 percentage points. That’s a large impact, relative to an overall standard deviation of MMF net risky investment of 25 percent over the period analyzed.

Overall, my paper shows how a theoretical model of fund competition can help us make sense of MMF behavior in a low-rate environment and understand how their risk-taking responds to market conditions and monetary policy. In particular, the paper shows that when risk-free rates decrease, rather than reaching for yield, all funds decrease their holdings of risky assets because they need a larger buffer of safe assets to keep their default probability at the preferred (equilibrium) level. In contrast, surges in risk premia have opposite effects across funds: those with low default costs take more risk, whereas those with high default costs take less.

The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

Gabriele La Spada Gabriele La Spada is an economist in the Federal Reserve Bank of New York’s Research and Statistics Group.

How to cite this blog post:
Gabriele La Spada, “Do Low Rates Encourage Yield Seeking by Money Market Funds?,” Federal Reserve Bank of New York Liberty Street Economics (blog), March 7, 2018,
Posted by Blog Author at 07:00:00 AM in Financial Institutions

Feed You can follow this conversation by subscribing to the comment feed for this post.


Thank you very much for reading the blog and for the very interesting question. According to my model, an increase in risk-free rates and risk premia, such as the one you describe in your question, would lead prime MMFs with relatively low default costs to increase their risk taking. However, the effect on prime MMFs with high default costs would be ambiguous because the increase in risk-free rates would lead them to take more risk, but the increase in risk premia (if it reflects an increase in underlying risk, as I assume in my model) would push them to take less risk. As a consequence, the effect on the overall industry is ambiguous. It depends both on the magnitude of the risk-free rate rise relative to the surge in risk premia and on the relative size of the two groups of funds (more specifically, on the distribution of default costs in the industry). Finally, as you rightly point out, keep in mind that the current environment is very different from the one I study in my paper, especially because of the new SEC regulation of the MMF industry, which requires all prime MMFs to adopt a system of liquidity gates and redemption fees and institutional prime MMFs to move from a stable NAV to a floating NAV.

Thank you for this very interesting work. How do you think your research relates to the current situations in markets, where commercial paper rates have been accelerating, and LIBOR/OIS spreads have been widening?

I'm not quite sure I understand what your model would argue the impact would be: risk premia is rising this year from extremely compressed levels last year, risk-free rates are rising, and LIBOR/OIS rates are widening, arguing that prime MMFs are reducing risk.

I recognize there are some potential exogenous impacts from the tax reform and fiscal stimulus/t-bill supply, but just curious your opinion. Thanks!

Verify your Comment

Previewing your Comment

This is only a preview. Your comment has not yet been posted.

Your comment could not be posted. Error type:
Your comment has been saved. Comments are moderated and will not appear until approved by the author. Post another comment

The letters and numbers you entered did not match the image. Please try again.

As a final step before posting your comment, enter the letters and numbers you see in the image below. This prevents automated programs from posting comments.

Having trouble reading this image? View an alternate.


Post a comment

About the Blog
Liberty Street Economics features insight and analysis from New York Fed economists working at the intersection of research and policy. Launched in 2011, the blog takes its name from the Bank’s headquarters at 33 Liberty Street in Manhattan’s Financial District.

The editors are Michael Fleming, Andrew Haughwout, Thomas Klitgaard, and Donald Morgan, all economists in the Bank’s Research Group.

The views expressed are those of the authors, and do not necessarily reflect the position of the New York Fed or the Federal Reserve System.

Economic Research Tracker

Liberty Street Economics is now available on the iPhone® and iPad® and can be customized by economic research topic or economist.

Most Viewed

Last 12 Months
Useful Links
Comment Guidelines
We encourage your comments and queries on our posts and will publish them (below the post) subject to the following guidelines:
Please be brief: Comments are limited to 1500 characters.
Please be quick: Comments submitted after COB on Friday will not be published until Monday morning.
Please be aware: Comments submitted shortly before or during the FOMC blackout may not be published until after the blackout.
Please be on-topic and patient: Comments are moderated and will not appear until they have been reviewed to ensure that they are substantive and clearly related to the topic of the post. We reserve the right not to post any comment, and will not post comments that are abusive, harassing, obscene, or commercial in nature. No notice will be given regarding whether a submission will or will not be posted.‎
Disclosure Policy
The LSE editors ask authors submitting a post to the blog to confirm that they have no conflicts of interest as defined by the American Economic Association in its Disclosure Policy. If an author has sources of financial support or other interests that could be perceived as influencing the research presented in the post, we disclose that fact in a statement prepared by the author and appended to the author information at the end of the post. If the author has no such interests to disclose, no statement is provided. Note, however, that we do indicate in all cases if a data vendor or other party has a right to review a post.