Breaking the Buck: Loss of Constant NAV in Money Market Funds

An in-depth examination of what it means when a money market fund's NAV falls below $1, causing significant implications for investors and the financial market.

“Breaking the buck” refers to an event in which the net asset value (NAV) of a money market fund falls below the usual $1 per share. This deviation signifies that the fund’s assets have decreased in value to a point where they no longer maintain the stable $1 NAV, typically due to severe losses or insufficient investment income to cover operating expenses.

Origins and Historical Context

Money market funds are typically considered low-risk investments, often utilized by individuals and institutions for their perceived safety and liquidity. Historically, these funds aim to maintain a stable NAV of $1 to provide stability and predictability. The first notable instance of “breaking the buck” occurred in 2008 when the Reserve Primary Fund’s NAV fell to $0.97 amid the financial crisis, leading to widespread panic and a run on money market funds.

Causes of Breaking the Buck

Severe Losses

A substantial decline in the value of the fund’s investments, such as default on securities or significant market downturns, can cause the NAV to drop:

$$ \text{NAV} = \frac{\text{Total Assets - Liabilities}}{\text{Total Shares Outstanding}} $$

Income Below Operating Expenses

If the return on the fund’s investments is insufficient to cover its operating expenses, the NAV may also decline:

$$ \text{Net Investment Income} = \text{Interest Income} - \text{Operating Expenses} $$

Types of Money Market Funds Susceptible to Breaking the Buck

• Prime Money Market Funds: Invest in corporate debt, carrying higher credit risk.
• Government Money Market Funds: Hold government securities, typically considered safer but not immune to extreme market conditions.
• Tax-Exempt Money Market Funds: Invest in municipal bonds, subject to different risks based on local government solvency.

Implications of Breaking the Buck

Investor Confidence

A drop below $1 can erode investor confidence, prompting redemptions and potentially exacerbating fund instability.

Regulatory Response

Post-2008, regulatory changes such as the SEC’s Rule 2a-7 have been implemented to increase transparency and reduce the risk of breaking the buck.

Examples and Case Studies

Reserve Primary Fund (2008)

The Reserve Primary Fund’s NAV fell to $0.97 on September 16, 2008, due to losses on Lehman Brothers’ commercial paper, sparking a large exodus from money markets.

Comparisons with Related Terms

• Net Asset Value (NAV): The per-share value of an investment fund.
• Run on the Fund: When numerous investors withdraw their funds simultaneously, often precipitated by fear of breaking the buck.

FAQs

What happens to investors when a money market fund breaks the buck?

Investors may experience losses on their investments and reduced access to liquid funds.

Are money market funds still considered safe?

Post-2008 reforms have strengthened safeguards, but money market funds still carry some risk.

References

• Securities and Exchange Commission (SEC). (2023). Money Market Fund Reform.
• Kacperczyk, M., & Schnabl, P. (2010). When Safe Proved Risky: Commercial Paper during the Financial Crisis of 2007–2009.

Summary

“Breaking the buck” disrupts the perceived stability of money market funds by destabilizing their steadfast $1 NAV. While considered rare, such occurrences underscore the necessity for prudent fund management and robust regulation to maintain confidence within the financial markets. Understanding the underlying causes, implications, and historical precedents allows investors and regulators alike to mitigate potential risks effectively.