Frequently Asked Questions About Money Market Funds and Credit Ratings on U.S. Treasury Securities
Why are news accounts and analysts discussing the impact of the U.S. debt ceiling and deficit debates on money market funds?
Failure to increase the U.S. debt ceiling or address the long-term U.S. spending and fiscal imbalance has the potential to adversely affect investors, markets, and economies across the globe—with severe consequences for interest rates, stock prices, investor confidence, and the day-to-day activities of businesses and consumers.
Money market funds own $684 billion in U.S. sovereign debt—securities issued by the U.S. Treasury and government agencies—and hold another $491 billion in repurchase agreements, most of which is collateralized by U.S. government debt. Money market funds are required to invest only in short-term, highly liquid securities that present minimal credit risk. Analysts and news reports have focused on the repercussions of any policy or market developments that might affect the liquidity or credit quality of U.S. government securities.
What would be the impact for U.S. money market funds of a downgrade in the credit rating of U.S. sovereign debt?
That depends on many factors. One of the most important is whether any downgrade affects only the U.S. government’s long-term credit rating, or applies to both long-term and short-term debt. A money market fund’s ability to purchase or hold a rated security depends on the issuer’s short-term credit rating.
Most of the discussion to date has focused on downgrades to the AAA/Aaa rating on the United States’ long-term debt. However, unless the credit rating agencies designated as Nationally Recognized Statistical Rating Organizations (NRSROs) also downgrade short-term debt issued by Treasury and other federal agencies, money market funds would not be affected by any change in the AAA/Aaa rating.
Would a downgrade in the short-term credit rating for U.S. sovereign debt force money market funds to dispose of their holdings of U.S. government debt?
That’s unlikely. Credit rating agencies would have to cut their ratings on short-term U.S. government securities steeply—by an amount roughly equivalent to eight steps on the long-term rating scale—to force such an action. None of the major credit rating agencies has discussed a downgrade of U.S. government debt of that severity.
Here’s why: A security rated by multiple NRSROs is eligible for purchase by money market funds if two or more of those NRSROs rate the security in either their highest (“First Tier”) or second-highest (“Second Tier”) short-term rating levels. The U.S. government’s short-term debt is currently rated First Tier by all the NRSROs that have issued short-term ratings.
A downgrade of U.S. government short-term debt from First Tier to Second Tier would not preclude money market funds from purchasing or holding U.S. government securities. Nor would it require money market funds to sell their current holdings of Treasury and other government securities.
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 (see table below). 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.
Moody’s Investor Services uses “P-1” and “P-2” as its symbols for the two highest short-term ratings categories. Standard & Poor’s Rating Services uses “A-1+” and “A-1” for First Tier and “A-2” for Second Tier. Fitch Ratings Ltd. uses “F-1+” and “F-1” for First Tier and “F-2” for Second Tier.
The following table shows how these major credit rating agencies align their long-term and short-term ratings, and which short-term ratings constitute First Tier and Second Tier:
|Money market fund category||Moody's||Standard & Poor's||Fitch|
|Eligible securities||First Tier||Long-term||Short-term||Long-term||Short-term||Long-term||Short-term|
|Ineligible securities||Third Tier||Baa2*
|Ba1 to B3
Caa1 to Ca
|Not Prime||BB+* to CCC*
B* to CC
|BB+ to B-
CCC to C
|In default||C||Not Prime||SD, D||SD, D||RD, D||RD, D|
*Due to the inherent complexities in comparing long-term risks with short-term risks, all three agencies allow some overlap in rating categories.
Sources: Moody’s Investor Services, Standard & Poor’s Global Credit Portal, Fitch Ratings, Bank for International Settlements
As the table shows, short-term rating bands are broader and contain fewer rating “steps” than long-term ratings. Thus, a decline from A-1/P-1 to A-2/P-2 in short-term ratings is much larger than a decline from AAA/Aaa to AA/Aa2 for long-term debt. An issuer whose long-term rating was downgraded from AAA to AA would still be rated A-1+ and First Tier for short-term debt.
Are there credit factors other than ratings that money market funds must consider when buying or holding securities?
Yes. A money market fund must limit its investments to securities that pose a “minimal credit risk,” as determined by the fund’s board. That determination is made independently of any credit rating. The board of directors normally delegates the power to make that determination to the fund adviser, following policies set by the board.
Would money market funds be able to add U.S. government securities to their portfolios if the U.S. government’s short-term credit rating falls to Second Tier?
Yes. The SEC’s Rule 2a-7—the rule governing money market funds—deems government securities to be First Tier securities so long as they are eligible for purchase (i.e., rated in the First or Second Tier by two or more NRSROs). Rule 2a-7 places no limits on the share of a fund’s portfolio that can be invested in First Tier securities. In addition, while Rule 2a-7 generally limits a money market fund’s holdings of securities from any one issuer, that diversification requirement does not apply to U.S. government securities.
Any decision to purchase U.S. government securities would depend on the fund’s determination that those securities continue to pose minimal credit risk.
In the unlikely event that short-term U.S. sovereign debt were downgraded below Second Tier, what would money market funds be required to do?
If short-term U.S. sovereign debt were downgraded below Second Tier, a money market fund would be required to dispose of the downgraded securities in an orderly manner, unless the fund’s board determines that disposing of the securities would not be in the best interests of the fund and its shareholders.
What would be the consequences of failure by the U.S. Congress and Administration to raise the debt ceiling by August 2, 2011?
The U.S. Treasury projects it will exhaust its legal borrowing authority on August 2 unless the statutory debt ceiling is raised from its current level of $14.3 trillion. In that event, Treasury says, “the government would have to stop, limit, or delay payments on a broad range of legal obligations, including Social Security and Medicare benefits, military salaries, interest on the national debt, tax refunds, and many other commitments.” Policymakers have discussed a number of options for giving priority to particular obligations (e.g., military salaries and Social Security payments).
If the U.S. government fails to pay interest or principal when due on a security in a money market fund’s portfolio, the fund must dispose of the security in an orderly way, unless the fund’s board determines that disposing of the security would not be in the best interests of the fund and its shareholders. The board may consider market conditions, among other factors, in making that decision. If the security accounts for 0.5 percent or more of the fund’s portfolio, the fund also must report the default to the SEC.
In addition, the U.S. government’s failure to pay its obligations could trigger a severe downgrade of its short-term credit rating by NRSROs. In that case, U.S. government securities may no longer be eligible securities (i.e., may no longer be rated First or Second Tier by at least two NRSROs), or a money market fund’s board or its delegate may determine that the credit risk of those securities is no longer minimal. In either of those events, the fund would be required to dispose of those securities, unless the fund’s board determines that disposing of the securities would not be in the best interests of the fund and its shareholders.
Why might a money market fund’s board of directors choose not to dispose of a defaulted or severely downgraded security?
Rule 2a-7 requires a money market fund to dispose of a security that is no longer eligible (i.e., First Tier or Second Tier) or has defaulted “as soon as practicable consistent with achieving an orderly disposition,” unless the board finds that “disposal of the security would not be in the best interests of the money market fund (which determination may take into account, among other factors, market conditions that could affect the orderly disposition of the portfolio security)…”
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.