from Liberty Street Economics

— this post authored by Gabriele La Spada

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 reportfrom 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).