Money Market Instruments: Advantages and Types

In India, there’s simply no dearth of investment options. Money market instruments are one among the many financial instruments you can currently invest in. Investing in these financial assets is a great way to diversify your portfolio and reduce risk. But then, what are money market investments and are there any benefits or disadvantages associated with them? Continue reading to learn everything about this unique investment option. 

What are Money Market Instruments?

Money market instruments are financial assets with a short maturity period and high liquidity. One of the defining traits of such kinds of investments is the low risk that they’re often associated with. The returns from these instruments are generally in the form of fixed interest payments, making them ideal investment options for investors looking for guaranteed returns with low risk. 

Money market instruments are widely known and popular among institutional and retail investors for their stability and ability to be quickly converted to cash by trading them on exchanges or the over-the-counter (OTC) market. 

What is the Purpose of Money Market Instruments? 

Money market instruments are typically issued by both companies and governments for a wide range of reasons. Let’s look at a few reasons why these financial assets are issued. 

• Major Source of Funds

Money market instruments are a major funding source for governments. The funds raised by issuing these financial instruments are often used for meeting trade-related obligations and even for short-term developmental activities. 

• Short-Term Financing 

Both companies and governments have short-term financing and working capital requirements. The issuance of money market instruments allows them to effectively meet their temporary funding needs and bridge liquidity gaps. 

• Influences Economy 

The Reserve Bank of India often uses money market instruments to boost liquidity in the economy by influencing the money supply. 

Advantages of Money Market Instruments

Money market instruments offer plenty of advantages to investors. Here’s a quick glimpse of some of the key benefits of investing in these assets. 

• High Liquidity 

Unlike many other investments, you don’t have to remain invested in money market instruments till maturity. You can liquidate your investments by selling them on the exchange or through the OTC market at any point in time. 

• Low Risk 

The risk associated with money market instruments is very low. In the case of securities issued by the government, there’s no default risk since they enjoy sovereign guarantees. 

• Attractive Returns 

The returns from certain money market instruments are sometimes higher than a few popular investments. Furthermore, you get to enjoy fixed, non-market-linked returns. 

Disadvantages of Money Market Instruments 

As with any other investment option, money market instruments also have certain disadvantages. Let’s look at a few of them. 

• Interest Rate Risk 

One of the major limitations of money market instruments is interest rate risk. For instance, if the interest rates in the economy rise, the yield on existing money market investments will become less attractive and vice versa. 

• Limited Growth Potential 

Since the returns from money market instruments are not market-linked, it has very limited growth potential and offers limited capital appreciation. In some cases, the returns from the instruments may not even be enough to tackle inflation. 

What are the Types of Money Market Instruments?

Money market instruments can be classified into as many as 6 different types. As an investor, it is crucial for you to know what they are. Here’s a detailed overview of some of the common types of money market instruments. 

1. Treasury Bills (T-Bills) 

Treasury Bills are short-term financial instruments issued by the Reserve Bank of India. Issued in 91-day, 182-day or 364-day tenures, T-Bills are zero-coupon securities, meaning that they’re issued at a discount and are redeemed at par value. The difference between the discounted purchase price and the par value of the security is the return. 

2. Commercial Paper (CP)

Commercial Paper is an unsecured financial instrument issued by companies. As with T-Bills, CPs are also zero-coupon securities and are issued at multiples of ₹5 lakh. Commercial Paper carries a slightly higher risk compared to other money market instruments due to its unsecured nature. 

3. Repurchase Agreements (Repos) 

Repurchase Agreements are agreements between two parties. Here, one party sells securities to another with the promise to repurchase the sold securities at a future date at a predetermined price. 

4. Certificate of Deposit (CDs) 

Certificate of Deposit is a financial instrument issued by a bank or a financial institution. According to the directions of the RBI, banking institutions are permitted to issue CDs for tenures ranging from 7 days to up to a year. Other eligible financial institutions, meanwhile, can issue CDs with tenures ranging from 1 year to 3 years.  

5. Short-Term Government Bonds 

Issued by the Reserve Bank of India, Short-term government bonds are very similar to Treasury Bills but have slightly longer tenures. And unlike T-Bills, short-term government bonds need not always be zero-coupon securities. They may also be issued as regular securities that provide a fixed interest rate at regular intervals. 

6. Banker’s Acceptance (BA) 

As the name implies, a Banker’s Acceptance is a financial instrument issued by banking institutions. It represents a guarantee of future payment of a predetermined amount and is typically issued at tenures ranging from 30 days to 180 days. 

Who Should Invest in Money Market Mutual Funds?

Money market instruments are hugely popular among large institutional investors like mutual funds, banks, financial institutions and corporations. This reduces the chances of investing for individual investors. Additionally, individual investors may not get access to all of the different types of money market instruments. 

Here’s where money market mutual funds come into the picture. They’re basically mutual funds that invest a major part of their assets in a wide range of short-term, high-quality money market instruments. They’re designed to provide individual investors with a way to gain exposure to money market instruments that they may not always have access to. 

Conservative investors with a penchant for low-risk investment options may consider investing in money market mutual funds. Alternatively, investors looking for a highly liquid investment or an avenue to park their excess funds temporarily may also choose to invest in these funds. 

Things to Consider Before Investing in Money Market Mutual Funds

If you find money market mutual funds an attractive investment option, here are a few things you need to account for before investing in them. 

• Investment Tenure

Your investment tenure is a major factor that you need to consider before investing in money market mutual funds. Consider investing in these funds only if your investment tenure is short, i.e., up to a year. 

• Expense Ratio

All mutual funds levy a charge known as an expense ratio. It is the fees that the Asset Management Company (AMC) levies for managing the fund’s investments. When investing in a money market fund, make sure to check its expense ratio. The lower the expense ratio, the better. 

• Market-Linked Performance 

Money market funds’ performance is directly linked to the interest rates in the economy. If the interest rates rise, the funds may underperform. This is something that you need to keep in mind before investing. 

• Taxation 

Since you would be investing in money market funds only for the short term, your gains would be classified as short-term capital gains (STCG), meaning that you would have to pay a tax of 15% on your mutual fund returns. 

Also Read More About Short Term Capital Gain on Mutual Funds

Conclusion

Money market instruments are a great low-risk investment option for investors looking for safety and liquidity. However, the lack of long-term capital appreciation makes them an unsuitable option for all kinds of investors. 

Therefore, before you decide to invest in money market instruments, make sure to carefully assess factors like your investment goals, risk profile and time horizon. Doing so will allow you to make a well-informed investment decision in line with your requirements.

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