Money market instruments are essential for proper investment portfolio diversification. They are also the preferred investment choice for persons with low risk appetite and/ or short investment tenure. But what exactly is a money market instrument (or security)? How do they work? What makes them the preferred option for the low risk investor? Are they regulated?
The Money Market (MM) is where liquid financial instruments with relatively short tenures (maturities) are traded. An MM instrument, sometimes called a bond, is actually a debt. The investor (bondholder)grants the bond issuer a short-term loan to enable the bond issuer meet operating expenses. In return the bondholder is paid an interest at an agreed interest rate (aka coupon rate) at agreed times, and at the maturity of the bond, the investor collects the original sum invested. Compare this to investment in company shares (equity), where the investor never gets the original sum invested back, because the money was used to buy her portion of the company; but she will receive dividends whenever the company makes profits.
These instruments can be easily converted to cash. They have a record of safety as default on payments are rare. Returns are predictable, hence the other name for MM instruments is Fixed Income instruments. They are issued by governments (national and sub-national), banks and companies. They can be secured or unsecured. Federal government bonds are generally classified as risk free because they are backed by the might of the country’s central bank. In Nigeria, they include the popular treasury bills (TBs), FGN savings bonds and FGN bonds. Interest earned from FGN instruments are tax exempt and therefore are not subject to the 10% withholding tax payable on other MM instruments. In addition, treasury bills pay the interest upfront; so, under the principle of time value of money, the interest received is actually higher in value than if it was received backend because the investor gets to use the money 90 days (depending on the tenure) earlier. The combination of upfront and tax-free interest makes TBs an excellent MM instrument.
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State government bonds are also available. State governments issue them in order to generate bulk amounts of money to fund key infrastructure projects. A good example of a bond funded project is the Lagos Light Rail project between Marina and Mile 2. The dwindling resources of state governments need not alarm investors as they are protected by the terms of the Bond; such that money for payments to bondholders are deducted from states monthly statutory allocations first, before the governors have access to the allocations. Sadly, this has worked against many states because the proceeds from the bonds were not faithfully invested in economy boosting projects. So successive governments pay the debts that preceding governments acquired without obtaining any accompanying benefits.
Corporate bodies also issue bonds. There are two main categories – commercial papers (CPs), which are unsecured bonds and bankers’ acceptances, which secured because they give the investor recourse to a bank in the event that the bond issuer defaults. Therefore, in buying CPs, the investor must ensure that only the best run companies are considered. Real estate developers also issue longer tenured bonds for the development of residential, commercial or infrastructure projects.
Fixed deposits are another form of MM – they are loans to banks for a specified number of days, which the banks use to fund their operations, that is lending to their customers. This is the reason banks frown are liquidating fixed deposits before maturity; they have relied on such deposits, lent out the money and in most cases, the borrower is not due to repay.
MM instruments have low risk and are very liquid. They are excellent instruments for the investment portfolio of risk averse investors especially pensioners, who are more interested in preserving the value of their investment than in growing it. This low risk nature of MM instruments makes them deliver relatively lower returns, remember – the higher the risk, the higher the return. Investment in equities may ultimately deliver higher returns but they do not give any guarantee of return or capital preservation.
MM securities are regulated by the Securities and Exchange Commission (SEC). They are listed on the FMDQ Exchange (the MM equivalent of the Stock Market) for both initial offerings and secondary trading. To guide your due diligence, look out for the rating given the instrument by reputable rating agencies like Agusto and Co.
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