Competition, Reach for Yield, and Money Market Funds

Abstract:

Do asset managers reach for yield because of competitive pressures in a low rate environment? I propose a tournament model of money market funds (MMFs) to study this issue. I show that funds with different costs of default respond differently to changes in interest rates, and that it is important to distinguish the role of risk-free rates from that of risk premia. In an environment in which funds care about relative performance, an increase in the risk premium leads funds with lower default costs to increase risk-taking, while funds with higher default costs reduce risk-taking. Without changes in the risk premium, low risk-free rates reduce risk-taking. I show that these predictions are consistent with the risk-taking of MMFs during the 2006-2008 period: When risk premia increased, funds with low sponsor's reputation concerns increased risk-taking, while funds with high sponsor's reputation concerns decreased risk-taking. Further, I confirm the differential role of risk-free rate and risk premium to explain changes in fund portfolios.