The recent regulatory focus on money market funds both in Europe and the US has turned attention back to the ways in which fund interest rate risk is measured. The two most common variables are weighted average maturity (WAM) and weighted average life (WAL).
Weighted Average Maturity (WAM)
The traditional WAM calculation is a basic measure of a money market fund’s maturity profile. To calculate the WAM of a portfolio, each security’s percentage of the total of the portfolio is multiplied by its interest reset date and these numbers are then summed.
Take a $10m portfolio containing the following four bonds:
$4m with a 60 day maturity
$3m with a 28 day maturity
$1m with a 20 day maturity
$2m with a seven day maturity
The weighted average maturity is \(\mathrm{{0.4}\times{60}\mathrm\:+\:{0.3}\times{28}\:+\:{0.1}\times{20}\:+\:{0.2}\times{7}}=\mathrm{{24}\:+\:{8.4}\:+\:{2}\:+\:{1.4}}=35.8days \)
It should be noted that in the US, when calculating WAM under SEC Rule 2a-7, a fund adviser is permitted to use the interest-rate reset date, rather than a security’s stated final maturity, for variable- and floating-rate securities. By looking to a portfolio’s interest rate reset schedule in lieu of final maturity dates, the WAM measure effectively captures a fund’s exposure to interest rate movements and the potential price impact resulting from them: a longer weighted average maturity implies greater volatility in response to interest rate changes.
This is why the SEC has reduced the maximum WAM permissible for money market funds. A fund with a 90-day WAM can withstand an instantaneous change in interest rates of 200 basis points before breaking the buck. Breaking the buck is the phrase used to describe a fund’s inability to repay investors at par. In contrast, a fund with a WAM of 60 days can withstand an interest rate change of 300 basis points without breaking the buck. Also, a fund with a 90-day WAM facing a change in credit spreads of 50 basis points and redemptions of 10% would break the buck with an interest rate change of a little more than 100 basis points. A fund with a 60-day WAM would be in a better position to withstand multiple shocks without breaking the buck than if it maintained a 90-day or 75-day WAM.
However, because of its potential reliance on interest rate reset dates, WAM does not measure the risk faced by a fund required to hold its entire portfolio of securities to their final maturities. To do this, another measure is needed.
Weighted Average Life (WAL)
The WAL calculation is based on a security’s stated final maturity date or, when relevant, the date of the next demand feature when the investing fund may receive payment of principal and interest. Accordingly, WAL reflects how a portfolio would react to deteriorating credit or tightening liquidity conditions.
So in contrast to WAM, in this calculation the time weightings are based on the final principal repayments – again, the higher the dollar amount, the more weight that corresponding time period will have.
The SEC has just restricted the maximum weighted average life of a fund’s portfolio to 120 days. The effect of the restriction is to limit the ability of the fund to invest in long-term floating rate securities using the WAL definition to shorten the maturity of an adjustable-rate security by reference to its interest rate reset dates. Longer-term securities are more sensitive to credit spreads than short-term securities with final maturities equal to the reset date of the longer term security. This means that they are more likely to deviate significantly from their amortised cost, so raising the possibility that the fund will break the buck in the event of market disruption.
Treasurers should use both WAL and WAM together in order to obtain a clear picture of the interest rate and credit spread risks run by the funds in which they invest.
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