The funds, including those run by PIMCO, Federated Investors Inc and the largest money fund sponsor - Fidelity Investments - are shying away from government debt that matures in the next few months and keeping more cash on hand to help them withstand any delays in the U.S. paying its creditors.
So far, investors have not been rushing to yank their money from the funds, as many still expect that Republicans will come to an agreement with Democrats over the nation's borrowing limit and avert a default. The U.S. Treasury expects to exhaust all of its remaining borrowing capacity by October 17.
But if the United States fails to raise its debt limit and repay maturing debt, panicky investors may look to raise cash, in part by withdrawing from money market funds. The funds would have to find ways to pay back their investors, either with cash they have on hand or by selling assets. The industry could face one of its biggest tests since the financial crisis forced the government to provide emergency support to the industry.
Funds are avoiding Treasuries that mature toward the end of October or the first half of November, which might miss paying their coupons and might therefore be tough to sell to meet investor redemption demands, said money fund analyst Peter Crane.
The period October 24-November 15 is the "game of chicken zone," Crane said. Only $74 billion of the total $475 billion of Treasury supply held by money funds matures during that period, he added.
Investors' reluctance to buy short-term Treasuries is clear in the market.
Interest rates on one-month U.S. government debt hit their highest levels in five years on Tuesday. And the Treasury sold $30 billion in four-week bills at 0.35 percent, the highest yield since October 2008. Demand was at its weakest in four-and-a-half years. Investors have become concerned about the potential for a missed payment if the Treasury's borrowing authority is not extended with an increase in the debt limit.
"The market isn't (worried about) a long-term default. The concerns are about liquidity," said Jerome Schneider, who oversees the $345 million PIMCO Government Money Market Fund and the larger, $15 billion PIMCO Short-Term Fund.
PIMCO's funds have avoided Treasuries that mature from mid-October through mid-December on concerns that those notes might face a repayment delay, Schneider said.
Money market funds must have at least 30 percent of their assets in cash, U.S. Treasuries, or other government securities maturing within 60 days, or securities they can convert into cash within a week, according to 2010 rules produced by the Securities and Exchange Commission.
Fidelity, with $430 billion in the investments, said its money market funds do not own any securities issued by the U.S. Treasury that mature in late October or early November.
"In addition, we have increased the amount of cash in our U.S. Treasury funds," Boston-based Fidelity said in a statement. "Also, we have stress-tested our money market mutual funds, and we believe they can withstand significant market volatility - far more than the historical largest one-day move in three-month U.S. Treasury bills that occurred in the last 40 years."
SO FAR, LITTLE FEAR
Problems in money funds threatened to freeze up global markets in 2008, after Lehman Brothers went bankrupt. A major money market fund that held Lehman debt was overwhelmed by investor redemption requests and failed - the value of its shares fell below $1 apiece, known as "breaking the buck." At least 21 other prime funds received support from their parent companies to avoid a similar fate, a Federal Reserve study later found. The U.S. Treasury temporarily supported money market funds as the crisis intensified.
Rule changes in 2010 made money market funds more transparent about their holdings, and the SEC is now weighing additional reforms designed to protect the funds from collapsing at times of stress.
John Bellows, investment strategy analyst for Legg Mason Inc's Western Asset Management unit, said the company's core funds hold more longer-term bonds than their benchmarks, which would help in case a stalemate in Washington creates market turbulence.
But so far, investors in the money fund industry have not shown signs of being rattled by the U.S. budget and debt crisis. They pumped $40.4 billion into money funds during the month of September as some got nervous about owning stocks.
During the first nine months of 2013, though, money funds have seen net outflows of $17.3 billion, according to Lipper Inc data. Part of the outflow is tied to the prolonged period of rock-bottom interest rates, which have resulted in paltry yields for money fund investors.
(Reporting by Tim McLaughlin; Editing by Dan Wilchins and Chris Reese)
By Tim McLaughlin and Ross Kerber