Money market funds are required by law and by their own charters to hold only high-quality securities. So if the ratings agencies downgrade the credit of the United States, will they have to sell their Treasury holdings?
This is a question that quite rightly has investors nervous. Money market funds are major holders of U.S. Treasurys. If they were all forced to suddenly dump their Treasury bonds because of a downgrade, the market would be flooded, prices would tumble and markets would become quite chaotic.
Fortunately, this fear is overblown. The SEC’s regulations for money market funds do include a rating requirement for money market fund investments—but that requirement is so loose that it is unlikely to trigger a forced sell-off.
The first place to start is to notice that all that matters is the short-term credit rating. This is the rating that might be downgraded if the U.S. doesn’t reach a deal to raise the debt ceiling, making a quick default likely. The latest noises out of Washington, D.C., indicate there’s almost no chance of that happening.
A downgrade of the U.S. government’s long-term credit rating might come about if Moody’s or S&P decide that the debt ceiling deal plugs a short term hole in our budget while not addressing the issue of sustainability. This might have other market effects, but it won’t trigger any regulatory requirement for a money market fund sell-off.
All that matters is the short-term credit rating, as far as the regulations are concerned.
But let’s say the ratings on short-term U.S. government securities get cut? Does that trigger a mandatory sell-off? Probably not.
The regulations say money market funds can purchase securities that agencies rate in their highest (or “First Tier”) or second-highest (or “Second Tier) rating levels. Those tiers each include a number of ratings. The First Tier starts at AAA and goes all the way down to single A, in S&P’s categorizations. The Second Tier goes all the way down to BBB.
Here’s a helpful chart from the Investment Company Institute that shows the ratings levels eligible and ineligible for acquisition by money market funds.
Downgrading the U.S. government’s short-term rating below Second Tier would be the equivalent of taking its long-term credit rating down by approximately eight steps, from AAA/Aaa to BBB+/Baa2. Indeed, even to reach Second Tier, a downgrade must be equivalent to taking the United States’ long-term credit rating down by approximately six steps. None of the discussion by major credit rating agencies has contemplated a downgrade of U.S. government debt of that magnitude.
In short, there won’t be a forced sell-off unless the short-term debt of the U.S. government gets downgraded much, much further than anyone imagines.
What’s more, even if the ratings were downgraded to below Second Tier, the regulations are not a suicide pact requiring a fire sale. Money market funds would not be required to sell Treasurys if they can dispose of them in an orderly manner or if they can only sell them at prices so low that the sale isn’t in the interest of the fund.
This ability to hang onto Treasurys if the market becomes disordered or if the sale isn’t in the interest of the fund applies even if the US government actually defaults on its debt. If a default has triggered a market panic or that the U.S. will eventually make good on its debt obligations, money market funds can simply hang tight.
“In unsettled markets following a default on U.S. government securities, a board may determine that disposal of its U.S. Treasury securities would not be in the best interests of the fund or its shareholders, particularly if the default promised to be of short duration,” the ICI explains.
This doesn’t mean that we won’t see money market funds selling in the event of a downgrade or a default. It’s possible that a broad sell-off of Treasurys could push bond pricesdown so far that some money market funds “break the buck” because their asset values fall below the $1 per share level. In that case, investors might withdraw money from the funds, forcing a sell-off under less than optimal conditions.
But the opposite is also possible. A downgrade could cause a panic in other asset classes, especially stocks. In that case, money might pour into money market funds. Many investors might look past a “break the buck” moment and understand that the asset values of the money market funds are likely to be only temporarily depressed. With more money coming into the funds, they might actually buy more Treasurys—as long as the downgrade didn’t push the short-term debt below the Second Tier.
Another possibility is that money market funds could see any price plunge following a downgrade of U.S. debt as a buying opportunity, repositioning themselves out of other securities and into government bonds.
There may even be technical, risk management reasons to buy downgraded Treasurys. If a huge portion of your portfolio gets downgraded from triple-A to double-A, in order to rebalance your risk exposure you would sell the riskier asset classes—your single As. You’d buy the double-As since those are now the least risky things around. So, ironically, to bring your risk back into balance, you buy the downgraded debt.
In short, there’s no reason to assume a downgrade of U.S. debt would force a fire sale by money market funds. (Incidentally, insurance companies won’t have to sell off either.) In fact, it might trigger opportunistic buying.
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