Will interest rate cuts reduce returns on money market funds?
Sam Benstead looks at the outlook for the increasingly popular money market fund sector.
11th September 2024 11:03
by Sam Benstead from interactive investor
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The rise in popularity of money market funds has been one of the standout investment stories of the past two years.
Before interest rates began to rise at the end of 2021, money market funds offered returns that were barely positive, as yields are linked to central bank interest rates which sat just above zero.
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These types of funds invest in secure bonds maturing soon, often in a couple of months, and also make use of overnight deposit facilities at banks. They are designed to be a “cash equivalent” that investors can hold inside their ISA or SIPP.
But rising interest rates caused yields to jump and now funds pay more than 5% on an annualised basis.
Popular money market funds include Royal London Short Term Money Market, L&G Cash Trust and Fidelity Cash.
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However, now that interest rates have begun to fall in the UK, with the Bank of England cutting rates from 5.25% to 5%, and the US Federal Reserve potentially set to cut this month, the outlook for money market funds is shifting.
Because money market funds invest in bonds maturing soon, yields reset quickly to market rates, rather than being locked in for longer periods. Deposit rates are also tied to the Bank of England’s base rate, which is the return that the central bank offer banks if they store their cash with it.
This means that yields are beginning to fall, even if it is not visible in the latest fund factsheets just yet, which are currently dated to the end of August or end of July.
Mark Munro, a fixed-income portfolio manager at abrdn, explains: “Yields have already begun to drop on money market instruments, and with two more interest rate cuts expected in the UK this year, they will fall further.
“We think that rates will finish the year at 4.5%, and then drop to 3% by the end of 2025, so returns will only fall from here and the opportunity for investors is dissipating.”
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- Everything you need to know about investing in gilts
Investors using short-term gilts as a cash-like investment are also being punished as interest rates fall. Yields on UNITED KINGDOM 2 07/09/2025 (LSE:T25), maturing in June 2025, and UNITED KINGDOM 0.125 30/01/2026 (LSE:T26), maturing in January 2026, are 4.4% and 3.7% respectively. Yields peaked around 5% a little over a year ago.
However, gilts carry an advantage over funds because capital gains are tax free. Therefore, if held outside an ISA or SIPP, buying gilts at a discount to their £100 redemption value can be very tax efficient.
But despite falling yields on money market funds, Craig Inches, manager of the Royal London Short Term Money Market fund, says they still actually yield more than some corporate bond fund sectors – and come with less risk.
This is because there is an inversion in the middle part of the bond yield curve, between one and 10 years, which means that very short-term bonds yield more than medium-term bonds. The longer-term bonds (more than 10 years until they mature) offer the most attractive yields. The yield curve is a chart that plots the relationship between yields and maturity dates. Normally, bonds with longer lifespans, such as 30 years, have higher yields than shorter-duration bonds that might be just a few years away from maturity.
Inches says: “Bond yields are driven by expectations around interest rates, and markets are already pricing in six cuts, which has brought yields down on a short-dated bond funds already.
“Moreover, because investment grade spreads – which is the extra yield over comparable safe government bonds – are at a tight 1%, some corporate bond funds only yield about 5%. Given that ultra-short cash rates are more driven by actual interest rates, not expectations, in a fund like mine you are getting a comparable yield with less risk.”
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This is backed up by data from Calastone, which tracks fund flows. It found that in the UK in August fixed-income funds saw outflows hit £516 million, the third worst on Calastone’s record, despite gains in bond prices. Meanwhile, safe-haven money market funds saw the largest inflows in a year at £592 million.
Where can you maximise return and minimise risk?
Munro says that adding some longer-dated bonds to a portfolio can increase yields, while keeping risk low.
His abrdn Short Dated Enhanced Income fund invests in corporate and government bonds maturing in less than three years and yields 5.5%.
Munro says the strategy delivers a return above cash with very low volatility. His view is that because short-term yields will fall the most quickly as interest rates come down, this fund can then move further down the yield curve, such as to bonds maturing in three years’ time, to deliver a yield boost that money market funds cannot achieve.
He adds: “There could be aggressive cuts in rates due to economic slowdown, leading to wider credit spreads, so active managers can pick up extra yield here in bond markets. There could also be opportunities in emerging market debt as well to offset falling government bond yields.”
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But Inches’ view is that investors should think about the wider investment context before adding risk.
“When interest rates are falling this means that the economic environment is getting worse, so it may not be the best time to add to corporate bonds or equities. If investors want to add more duration – which is the sensitivity of a bond to interest rates – then they could look at sovereign bonds that would benefit if there was a flight to safety assets.”
In his Royal London Short Term Money Market fund, he says that buying floating rate instruments – where the yield moves in line with interest rates – can add about 0.3% or 0.5% above overnight deposit returns, so he can deliver returns above the Bank of England base rate.
He also points to Royal London's Short Term Fixed Income and Short Term Fixed Income Enhanced funds which – while still being low-risk funds – add extra yield over money market funds. They currently yield 5.44% and 5.47%.
Other popular short-dated bond funds include Vanguard UK Short Term Investment Grade Bond Index and Fidelity Short Dated Corporate Bond fund.
While these funds will see some capital gains if interest rates fall more than expected, they will also decline in value if interest rates are higher than expected. This “duration” exposure is both an advantage and disadvantage of corporate bond funds over money market funds, depending on how markets move.
Advantages of a money market fund
- Very low risk, with the portfolio likely to at least hold its value and also pay out a modest income
- Diversified, meaning investors are not exposed to a single bond failing and can withdraw their money easily
- Can be held in a tax-friendly wrapper, such as an ISA or SIPP.
Disadvantages of a money market fund
- Investments may fall in value, unlike savings accounts
- Not suitable for growing savings over the long term as yields are typically below inflation
- Sensitive to interest rate fluctuations, with lower rates leading to lower yields. Yields rise when interest rates rise
- The Bank of England warns that in times of market panic and a rush to cash, there may be liquidity issues in money market funds.
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