We began our review of the fixed income asset class with some key terms.
As for the asset class, it is common to group fixed income debt into three categories: money market, bonds, and debentures. Today we will look at money market instruments.
Money Market Instruments
I consider almost all money market instruments to be Cash Equivalents within one’s investment portfolio. But as they are technically debt, and are influenced by many of the same variables as other debt issues, I will cover them here.
Money market instruments are part of the short term debt market used primarily by governments and large capitalized corporations with very strong credit ratings. By short term, less than one year until maturity.
Most money market instruments are issued at a discount and mature at face value. No actual interest is paid by the issuer. Rather the difference between the purchase price and the value at maturity is considered the interest.
In every jurisdiction I can think of, the amount earned between the purchase price and face value is treated as interest income, not a capital gain, for tax purposes.
However, if the money market instrument is traded in the secondary market prior to maturity, a portion of the return may possibly be treated as a capital gain or even capital loss.
Government Treasury Bills
For short term borrowings up to 1 year in duration, governments issue treasury bills (T-bills).
No interest is paid on T-bills. They are issued at a discount to face value equal to the required interest rate. Upon maturity, the face value is paid to the investor and the difference between the discount and par value is treated as interest income.
Longer term bonds that do not pay interest, but are issued at deep discounts, are known as zero coupon bonds.
T-bills are guaranteed by the issuing government of a country. Because of the ongoing solvency of most countries, the shorter term T-bills are considered the safest of all investments. As such, the interest rate on T-bills is normally viewed as the risk-free rate of return.
Note that the fortunes of countries rise and fall. At any given time, a specific country’s T-bills may not be risk-free. For example, US T-bills are considered totally safe as I write this post. However, countries like Belarus, Greece, and Venezuela may not be seen as 100% secure right now.
Like any debt instrument, the interest rate offered by the issuer will depend on its credit rating. The worse the credit rating, the greater the interest rate that needs to be paid.
Corporate Money Market Instruments
Often corporations require short term funding to pay for current liabilities or finance short term assets such as trade receivables or inventory.
On average, corporations are riskier than governments. That should be intuitive. Though this can obviously differ on a case by case basis. For example, Apple may have a market capitalization that would equate it in the top tier of most national governments. Or the current credit rating of Venezuela is lower than many companies.
But being generally riskier than governments, you should expect to see corporate money market instruments paying higher interest rates than similar short term government debt.
When corporations issue debt for periods up to one year, they have a variety of options. Three typical ones, include:
Commercial Paper
Unsecured debt issued by a company. Because the debt is not secured against any corporate assets, only companies with very strong credit ratings issue commercial paper.
Depending on the credit-worthiness of the issuer, these notes may be more or less risky. Interest rates offered on commercial paper will fluctuate between corporations based on their relative risk.
Acceptance Paper
Also know as Finance Paper or Asset-Backed Commercial Paper.
Secured debt that is issued by a finance or acceptance company. The issue is secured by specified assets such as receivables or inventory.
Assuming that the security is adequate to cover the issue, secured debt is normally less risky than unsecured debt.
For example, Debtcorp issues two classes of paper. One secured against its trade receivables and inventory. The other unsecured. The non-secured debt will require a higher interest rate to be offered to reflect the higher risk of the paper.
Banker’s Acceptances (BAs)
Debt issued by a non-financial corporation but where a bank guarantees its repayment.
Of the three corporate options, the least risky for investors. This is because there are two layers of protection with the involvement of the bank guarantee.
Because it is the least risky, all other things equal, BAs will offer the lowest returns.
Investing in Money Market Instruments
Most individual investors never directly invest in money market instruments. That is because the required minimum purchases are too high for many investors.
However, individual investors do purchase these instruments indirectly through money market funds (MMF). As you develop your investment portfolio, I would expect you to have a portion of your assets in MMF. Likely for your emergency funds, cash set aside awaiting investment opportunities, cash available for near term financial obligations, and so on.
While each investor is unique, normally investing in MMF is preferable to holding your cash in savings or chequing accounts. That is because MMF offer higher returns than bank accounts, tend to be low risk, and are highly liquid.
Depending on the financial institution, they usually offer better returns and greater liquidity than term deposits and Guaranteed Investment Certificates.
I think the key takeaway with money market instruments, and any other fixed income offering, is the risk-return relationship. The more risky the debt instrument, the more incentive must be offered to entice investors. For short term money market instruments, this will be in higher interest rates offered for riskier debt.
But for longer term debt, it may be in securitization of the debt or priority of repayment. Or it may be in other sweeteners like conversion privileges into common shares. We will review various sweeteners in the near future.
The higher the risk of a debt offering, the less desirable it is for investors, and the greater interest and/or sweeteners required to attract investors.
You can also look at this from basic demand driven economics that applies to any asset (eg., your vehicle, house, art, gold). You decide to sell your home. If there is substantial demand for your house in the local market (hot market, great house, attractive area, little else for sale, etc.), you can ask more money. If you are selling your home in a down market with few potential buyers, you may need to list for less.
The same logic applies for all types of debt and equity issues. The more attractive an asset is to the investor, the less a company must do to raise capital. The less attractive the asset, the more a company must pay to attract capital. We will see this over and over and over again as we explore different investments.
Next we will review bonds and debentures.
