Breaking the Buck: Why It Happens and How to Prepare

Breaking the buck is a serious concern for fixed income investors, and it's essential to understand why it happens and how to prepare.

A fixed annuity's crediting rate is usually higher than the current interest rate environment, which can lead to a situation where the insurer can't meet the promised payments.

Investors who are unaware of this risk may be caught off guard if the insurer fails to meet its obligations.

A notable example of this is the case of Executive Life Insurance Company, which broke the buck in 1991, resulting in significant losses for its policyholders.

Breaking the buck can happen due to a fund's investment income failing to cover its operating costs or investment losses. This can be a result of sudden shifts in interest rates, major credit quality downgrades for multiple firms, or increased redemptions that weren't anticipated.

Events like these can put pressure on a money market fund, making it more likely to break the buck. The fed funds rate dropping below the expense ratio of the fund can also produce a loss to investors.

To mitigate these risks, it's essential to understand what the fund is holding and to be aware that return is tied to risk. Investors should look for funds with lower fees, as this can increase return without additional risk.

Breaking the buck can be a complex issue, but it usually happens when a money market fund's investment income can't cover its operating costs or investment losses.

Typically, this is due to a combination of factors, including unusually low interest rates during an economic recession.

Low interest rates can make it difficult for money market funds to generate enough income to cover their expenses.

In some cases, breaking the buck can be a response to broader economic issues, such as a recession.

This highlights the importance of understanding the underlying economic conditions that can impact money market funds.

Events can put pressure on a money market fund, causing sudden shifts in interest rates, major credit quality downgrades, or increased redemptions.

Reviewing what the fund is holding is crucial, as you should understand what you're getting into. If you're unsure, it's best to look for another fund.

The return on a fund is tied to its risk level – the higher the return, the riskier it is. This is why looking for funds with lower fees can be a good strategy to increase return without increasing risk.

Major firms are typically better funded and can withstand short-term volatility better than smaller firms. In some cases, fund companies will cover losses to prevent the fund from breaking the buck.

Here are some key considerations to keep in mind:

Insecurity in the money market may not be as apparent as it seems, but it's a reality that can't be ignored. Historically, money market funds have been considered one of the safest investment options available.

In the 37 years leading up to 2008, not a single individual investor lost money in a money market fund. This record of safety is a testament to the reliability of these funds.

However, the 2008 financial crisis changed everything. The day after Lehman Brothers Holdings Inc. filed for bankruptcy, one money market fund fell to 97 cents after writing off the debt it owned that was issued by Lehman.

This created a potential bank run in money markets as investors feared that more funds would break the buck. The fear was real, and it's a reminder that even the safest investments can be vulnerable to market fluctuations.

Here's a brief timeline of money market fund breakdowns:

It's worth noting that the 1994 event was an institutional fund, and no individual investor lost money. But the 2008 crisis was a stark reminder that even the safest investments can be vulnerable to market fluctuations.

Breaking the buck is a relatively rare occurrence, with money market funds generally considered safe and reliable investments. According to Wilson, Linus, in his 2020 article "Broken Bucks: Money Funds That Took Taxpayers Guarantees in 2008", breaking the buck is not a frequent event.

Money market funds are known for their stability, and the U.S. Securities and Exchange Commission (SEC) has taken steps to ensure their reliability. In fact, the SEC's Administrative Proceeding File No. 3-9805 notes that the Reserve Primary Fund was the one that "broke the buck" in 2008, not the Federal Reserve.

The SEC's efforts to reform money market funds have also aimed to minimize the risk of breaking the buck. As stated in the SEC's "Money Market Reform; Amendments to Form PF", pages 10-11, 97, and 169-170, the goal is to make these funds even safer for investors.

In reality, breaking the buck is a serious event that can have significant consequences for investors. However, as the Vanguard Federal Money Market Fund's overview notes, the fund's goal is to provide a safe and stable investment option for its shareholders.

Breaking the buck can have serious consequences for investors, especially those who rely on stable value funds for their retirement savings. It can lead to a significant loss of principal.

Investors who put their trust in stable value funds may be surprised to learn that these funds often invest in lower-yielding assets, such as commercial paper and treasury bills, which can result in a loss of principal. This is because the yield on these investments may not keep pace with inflation, causing the fund's net asset value (NAV) to decline.

In some cases, the NAV of a stable value fund can drop below its original purchase price, a phenomenon known as "breaking the buck." This can be a devastating experience for investors who have come to rely on these funds for their retirement savings.

Money market funds are considered nearly risk-free, but they're not insured by the Federal Deposit Insurance Corporation (FDIC). This means investors are taking on some level of risk by investing in them.

These funds typically invest in short-term debt securities such as U.S. Treasury bills and commercial paper, offering a higher rate of return than standard-interest checking and savings accounts.

Investors often use money market funds as an additional source of liquid savings, alongside checkable deposit accounts.

Breaking the buck is a rare occurrence that can happen when the fund's value drops below $1, signaling economic distress.

Most money market funds have check-writing capabilities and allow money to be easily transferred to a bank account.

Breaking the buck can occur when interest rates drop to very low levels, or the fund uses leverage to create capital risk.

Money market funds have a fascinating history that's worth exploring. They were first introduced in the 1970s to make investors more aware of the benefits of mutual funds.

The first money market mutual fund was the Reserve Fund, which set the standard for a $1 NAV. This was a game-changer for the industry.

In 1994, a money market fund called Community Bankers U.S. Government Money Market Fund broke the buck, meaning its price fell to 96 cents due to large losses in derivatives. This was the first time this had happened.

The Reserve Fund was severely affected by the 2008 financial crisis, with its price falling below $1 due to assets held with Lehman Brothers. This caused panic among investors.

To address these issues, the government introduced new Rule 2a-7 legislation, which made money market funds much safer. This included provisions such as limiting portfolio maturity to 60 days and restricting asset investments.

When it comes to investing in funds, it's essential to consider the fees associated with them. Vanguard's money market funds have a management expense ratio of 0.11%.

Vanguard is a leader in money market fund products, offering a range of funds priced at $1. Its best-performing money market fund is the Vanguard Federal Money Market Fund (VMFXX).

A minimum investment of $3,000 is required to invest in the Vanguard Federal Money Market Fund, which has roughly 139 holdings with an average maturity of 60 days or less.

The fund has a net asset value of $214 billion, with investors receiving a return of 3.88% since its inception in July 1981.

This fund is also the most conservative of the Vanguard funds, making it a great option for those looking to minimize risk.

Money market funds have a safe track record due to their short-term debt maturity, with a weighted average portfolio maturity of 90 days or less. This allows portfolio managers to quickly adjust to changing interest rates.

The credit quality of the debt in money market funds is also a key factor in their safety. Typically, only 'AAA' rated debt is invested in, and no more than 5% of the fund can be invested with any one issuer, except the government.

This diversification of risk helps to minimize the impact of a credit downgrade on the overall fund. In fact, the risk of a credit downgrade is so low that even the rare case of a fund breaking the buck has only occurred in exceptional circumstances.

Large professional institutions participate in the money market, and their reputations are on the line if they fail to keep the net asset value (NAV) above $1. This adds an extra layer of safety for investors, as firms will do everything in their power to avoid breaking the buck.