A Money Market is referred to as a market for securities that have a short term maturity period of up to 1 year. A money market is inclusive of banks, non-banking financial companies, and acceptance houses and facilitates the transactions for short-term funds, along with maintaining appropriate liquidity in the market.
Understanding Money Market Funds
Money market funds are financial instruments having a short maturity period of up to 1 year. These funds are debt securities offering a fixed rate of interest and hence, are used as tools for raising capital by the issuer. However, money market funds are generally unsecured and involve a theoretically high risk of non-repayment.
While there is also no collateral backing up of the security in these funds, they tend to offer a high credit rating ensuring that issuers don’t default, which makes them a go-to avenue for investors looking for options to park their money for short term and earn fixed returns on the same.
Money market instruments, also known as long term borrowing instruments are grouped as ‘papers’ in contrast to ‘bonds’ and ‘shares’ and are traded on capital markets. One of the core drivers of money markets is inter-bank lending. Inter-bank lending refers to banks lending to and borrowing from other banks using money market instruments such as repurchase agreements and commercial papers. In India, the RBI regulates the REPO rate which is a benchmark rate to be used by domestic banks for the purpose of lending and borrowing from one another.
Features of Money Market Funds
Given below are a few points that you should know before you think of investing in money market instruments-
- High Liquidity
The maturity period of one year offered by these funds makes them highly liquid. Additionally, these funds tend to generate fixed income for the investors in such a short period; owing to which they are taken for close substitutes of money. Moreover, it is easy to trade money market instruments across currencies, maturities, debt structure as well as credit risk, which makes it ideal for institutions seeking to borrow or invest for the short term.
- Secure Investment
These financial instruments are considered one of the most secure investment avenues available in the market. Since issuers of money market instruments have a high credit rating and the returns are fixed beforehand, the risk of losing the invested capital is minuscule.
- Fixed returns
Since money market instruments are offered at a discount to the face value, the amount that the investor gets on maturity is decided in advance. This effectively helps individuals in choosing the instrument that would suit their financial needs and investment horizon.
- Physical trading
Money markets across the world essentially operate over the counter, which implies that the trading of these funds cannot be made online. Hence, investments in the money market are made physically by authorized representatives or in person. Later, a physical certificate is issued to the buyer of the money market instrument.
- Wholesale Market
Money markets are designed to provide and accept bulk orders. Thus, retail investors who have enough capital can directly participate in money markets, while individual investors must invest in debt mutual funds that invest in money markets in order to benefit from this market.
- Multiple Instruments
Unlike capital markets which usually trade in one single type of instrument, money markets trade is multiple instruments. These instruments differ in terms of maturity periods, debt structure, credit risk, currency, among others. Money market instruments are therefore considered ideal for diversification through exposure.
- Key Money Market Participants
Since money markets deal with only bulk orders, they are not open to individual investors. As a result of which, multiple institutional investors such as financial institutions and dealers looking to borrow or lend money for a short term participate in the trading of these instruments.
- Regulated by RBI
The Indian money market is controlled and regulated by the Reserve Bank of India. RBI is the only institution that can influence the organised sector, while the smaller unorganised sector is largely beyond its control. However, due to the considerably larger size of this organised sector, regulatory actions taken by the RBI can produce a substantial impact on the way in which this entire market operates.
Advantages of Investing in Money Market
Here’s why you should invest in the money market-
- Maintains Liquidity in the Market
One of the most crucial functions of the money market is to maintain liquidity in the economy. Some of the money market instruments are an important part of the monetary policy framework. RBI uses these short-term securities to get liquidity in the market within the required range.
- Provides funds on a short notice
Money markets allow investors to withdraw their funds on very short notice. Hence, it is advised that institutions borrow funds from the market instead of borrowing from banks, as the process is hassle-free and the interest rate is also lower than that of commercial loans. Sometimes, commercial banks also use these money market instruments to maintain the minimum cash reserve ratio as per the RBI guidelines.
- Utilisation of surplus funds
Money Market makes it easier for investors to dispose of their surplus funds while retaining their liquid nature and offering significant profits on the same. It facilitates investors’ (such as banks, non-financial corporations, state and local government) savings into investment channels.
- Financial mobility
The money market enables financial mobility to investors by allowing easy transfer of funds from one sector to another, thereby ensuring transparency in the system. High financial mobility is important for the overall growth of the economy as it promotes industrial and commercial development.
- Implementation of monetary policies
A developed money market helps RBI in efficiently implementing monetary policies. Transactions in the money market affect short term interest rate which gives an overview of the current monetary and banking state of the country. This further helps RBI in formulating the future monetary policy, deciding long term interest rates, and creating suitable banking policy.
Functions of Money Market
Money Markets have continued to exist in modern economies due to their unique features along with their ability to carry out certain key functions that other financial markets cannot. The five leading functions that a money market carries out in the modern economic system include-
- Providing Trade Financing
Modern day money markets play a vital role in ensuring that there is adequate capital available to institutions engaged in domestic as well as international trade. Internationally, short term funding for ventures may be available to traders through ‘bills of exchange’ apart from other routes. These are instruments that are discounted by the bill market. In common practice, discount markets and acceptance houses are engaged in financing overseas trading ventures using these ‘bills of exchange’.
- Ensuring Industrial Financing
Many industries and industrial houses issue bonds on the bond market or shares on the stock market in order to receive long term financing of their operations. There are two ways in which money markets help with industrial financing- providing short term funding and producing an impact on capital markets. Short term funding from money markets can help industries finance their day to day operations and meet working capital requirements. The long term capital is obtained by industries through the issue of bonds or shares on applicable capital markets. However, since the rate applicable to short term lending determines the applicable yield of long term capital market instruments, the market is clearly impacted by money market movements.
- High Liquidity Investment Solution
The money market offers a lucrative, low risk route to institutions such as commercial banks in using their excess funds to earn additional income. Commercial banks need to generate this additional income in order to ensure that they have sufficient liquidity so as to meet uncertain demands such as withdrawal of consumer deposits. Usually, commercial banks invest their funds in near money assets that have a short maturity period. This way, the banking sector is able to generate additional income while maintaining sufficient liquidity.
- Ensuring Self Sufficiency of Banks
Commercial banks operating in developed money markets have ample opportunities to invest and generate further income such that their self sufficiency improves in the long term. In case of dire cash crunch, banks can borrow funds from the RBI. Thus, money market instruments can help banks achieve their needs through the availability of funds at rates that are lower than those charged by the central bank. Additionally, money markets provide twin benefits of helping banks earn additional income and also acting as a source of funds to banks when required.
- Maintaining Money Supply for Central Banks
Central Banks are responsible for maintaining and controlling both the money market and capital market. As these markets operate using short term interest rates, they serve as an indicator of the country’s overall economic health. Such information provides accurate guidance to the central bank regarding how it should rectify any problems that might occur in the current situation. Thus, in the presence of a developed money market, the central bank has access to a secure, quick as well as effective way to influence various submarkets without having to overextend itself.
Types of Money Market Instruments
The money market in India is considered to be an agglomeration of multiple submarkets each featuring a different instrument that differs on the maturity period, the risk involved, etc. The following are some key money market instruments to be considered while investing in India-
- Treasury bills or T-bills are issued by the Reserve Bank of India on behalf of the Central Government for raising money
- T-bills do not pay any interest but are available at a discount to the face value at the time of issue. At maturity, the investor gets the face value amount. This difference between the initial value and face value is the return earned by the investor
- Treasury Bills are by far the oldest of money market instruments and are considered to be the safest short term fixed income investments as they are backed by the Government of India
- Since T-bills are issued by the government, they offer guaranteed returns and are known to be zero default risk investments. Additionally, T-bills have a short maturity period of up to 1 year
- T-Bills are commonly classified on the basis of their maturity period and their type.
- The maturity-based classification of treasury bills names them as 10-day TBs, 91-day TBs, 182-day TBs, and 364-day TBs
- The other classification includes auction bills and tap bills. Auction bills follow a multiple price system in order to ensure fair pricing.
- These bills are also termed as regular bills as they are available for investment by banks and other participating institutions
- Large companies and businesses issue promissory notes to raise capital from investors in order to meet their short term business needs. These promissory notes are known as Commercial Papers (CPs)
- The firms issuing commercial papers have a high credit rating, owing to which they are unsecured, with the company’s credibility acting as security for the financial instrument
- Corporates, primary dealers (PDs) and All-India Financial Institutions (FIs) can issue CPs
- CPs have a fixed maturity period ranging from 7 days to 270 days. However, investors can trade this instrument in the secondary market, wherever they offer relatively higher returns compared to that from treasury bills
Certificate of Deposit (CD)
- Certificates of deposit are financial assets issued by banks and financial institutions, offering a fixed interest rate on the invested amount, similar to a fixed deposit
- The primary difference between a CD and a Fixed Deposit is that of the principal amount. A certificate of deposit is issued only for large sums of money (1 lakh or in multiples of 1 lakh thereafter)
- Because of the restriction on the minimum investment amount, CDs are more popular among organizations than individuals who are looking to park their surplus for short term and earn interest on the same
- The maturity period of Certificates of Deposits ranges from 7 days to 1 year if issued by banks. However, other financial institutions also issue a CD with a maturity period of 1 year to 3 years
Repurchase Agreements or Ready Forward Contract (Repo)
- Also known as repos or buybacks, a Repurchase Agreement is a formal agreement between two parties, where one party sells a security to another, with the promise of buying it back at a later date. It is also called a Sell-Buy transaction
- The seller buys the security at a predetermined time and amount which also includes the interest rate at which the buyer agreed to buy the security. The interest rate charged by the buyer for agreeing to buy the security is called Repo rate
- Repos come-in handy when the seller needs funds for the short-term, s/he can just sell the securities and get the funds to dispose of. The buyer gets an opportunity to earn decent returns on the invested money
- Repo rate, fixed by the RBI may be defined as the rate at which domestic Indian banks borrow from other Indian banks or from the RBI. A decreasing repo rate makes it cheaper for banks to borrow money from other banks or the central bank. This, ultimately allows the bank to pass on the lower rate benefit to customers in the form of loans provided at reduced rates
- This is a financial instrument produced by an individual or a corporation in the name of the bank, wherein the issuer must pay a specified amount to the instrument holder on a predetermined date, between 30 and 180 days, starting from the date of issue of the instrument
- Banker’s Acceptance is issued at a discounted price, and the actual price is paid to the holder at maturity. The difference between the two is the profit made by the investor
- Banker’s acceptance is a secure financial instrument as the payment is guaranteed by a commercial bank
- Call money essentially represents a short term loan for the purpose of making stock exchange transactions with maturities ranging from 1 day to 14 days and is repayable on demand
- The call money market participants are allowed to lend and borrow using the call money instruments such as STCI (Securities Trading Corporation of India), DFHI (Discount and Finance House of India), co-operative banks and Indian and foreign commercial banks
- Call money loans feature a fixed interest rate, termed as call rate, which being closely related to changes in demand and supply, is quite volatile. Due to this high level of volatility, the call money market is considered to be the most sensitive section of India’s money market
Interest Rate Swaps
- Interest rate swap is referred to a financial transaction in which two parties sign a deal wherein one pays a fixed rate of interest, and the other pays a floating rate of interest
- The fixed rate of interest payable is calculated using a notional principal amount, while the floating rate of interest is paid on the actual principal lent out/borrowed with the rate varying on the basis of market conditions
- In India, interest rate swaps are mainly used by commercial banks. However, these are separate products that are not directly linked to the bank’s assets such as money lent to customers in the form of loans
This money market instrument protects the borrower from interest rates changes even though the borrower is on the hook for any variable markup payments not covered by the interest rate swap agreement
Who should Invest in Money Market Funds
Before you plan to invest in money market funds, ensure that your financial needs meet with the following-
- Money market funds offer a well-diversified portfolio of money market instruments
- These funds have a maturity period of just one year, which makes them suitable for investors with a short investment horizon
- Money market funds are considered one of the safest investment options because of their allocation of assets to only high rated instruments. Hence, investors with a lower risk appetite may give these funds a shot
- Money market funds hold the potential of offering higher returns in comparison to savings in a regular bank account
- Money market funds deal with bulk orders and require investors to pool in a huge amount of money; hence, they are suitable for large corporates and retail investors rather than individual investors
If you are an investor with a medium to long investment horizon, you may consider investing in dynamic bond funds or balanced funds instead of money market funds which may offer better returns in the long run
- Money market funds are considered ideal for older investors who would choose the safety of their corpus over growth
Things to be Considered
- Money market funds involve risk in terms of interest rate offered, credit and reinvestment, implying that as the interest rate increases, the value of the underlying asset declines. Hence, these are risky securities with a high risk of default
- While the money market holds the potential of offering higher returns than a regular savings bank account, the returns are not guaranteed. As the overall interest rate regime changes, the NAV fluctuates
- Money market funds are suitable only for investors with a short term investment horizon i.e. 3 months to 1 year. If you are looking to invest for a longer term, you may choose to invest in other debt funds
- Debt fund investments provide you with taxable capital gains. The tax rate is dependent on the time period for which you stay invested in the fund. For instance, if you were invested in a fund for less than three years, short term capital gains will be applicable to your investments
Though money market funds are safe, staying invested in them for a longer period of time will lower the returns in comparison with bonds
Related Article: Best Money Market Mutual Funds to Invest in 2020
Taxation on Money Market Funds
If an investor has made a capital gain of ₹50,000 on investment in a debt mutual fund and withdraws the amount before 3 years of investment, Short Term Capital Gains Tax would be levied, as per the income tax slab of the investor. ₹50,000 would be added to the taxable income of the investor and taxed accordingly.
If an investor withdraws the investment including capital gains post 3 years of investment, 20% Long Term Capital Gains Tax of 20% is levied, with the benefit of indexation.
Indexation reduces the value of overall Long Term Capital gains to reflect the effect of inflation on your investment.
To calculate the final value of capital gains post indexation, we use the government’s Cost Inflation Index (CII) in the following formula:
Indexed cost of Acquisition = Investment Amount * (CII of the year of withdrawal/ CII of the year of investment)
Suppose the investment amount is ₹70,000 in the year 2016 and the withdrawal amount is ₹1 Lakh. The value of capital gains is ₹30,000 before indexation
Indexed Cost of Acquisition= 70000* (280/254) = 77165.35
Note: CII in the year 2015 = 254
CII in the year 2018 = 280
Final Value of Capital Gains= 100000- 77165.35 = 22834.65
Tax Payable = 20% of 22834.65 = 4566.93
How to Invest in Money Market Funds
You can invest in money market funds through either of the following ways-
- Offline mode of investing– If you are not confident of your knowledge, you may choose to invest through a broker. However, investing in a fund through a broker will make you eligible for investments through regular plans that offer different returns and varied expenses in investment. If you wish to invest in the fund independently, you must visit the nearest branch of the AMC of your fund. Don’t forget to carry the following documents-
- Identity Proof (Aadhar Card)
- Canceled cheque
- Passport size photos (around 4-5)
- PAN Card
- KYC documents (for KYC verification)
- Online mode of investing– If you do not wish to add on to your expense of commissions or brokerage, you may visit online investment platforms such as Paisabazaar.com wherein you can choose from and compare more than 1,700 funds- all in one place, instead of following the long procedure of visiting the website of each AMC and then choosing from them. Here, you can select the fund in which you want to invest, look at the details and compare similar schemes as well as use SIP Calculator or Lumpsum Calculator to estimate the future value of your investment
Best Money Market Funds to Invest in 2020
Given the ideal investment horizon of one year, here is a list of 5 best money market funds that you may invest in-
|Fund Name||AUM (in Crore)||1-Year Returns (in %)|
|L&T Money Market Fund||902||8.51|
|SBI Savings Direct Fund||12,252||8.12|
|ABSL Money Manager||10,878||7.95|
|Nippon India Money Market||3,805||7.94|
Data as on 4 February 2020; Source: Value Research