By John McCrank

NEW YORK (Reuters) – Assets in money market funds have soared to record levels, drawing investors with their safe-haven appeal and yields that far exceed those paid on bank deposits.

The funds are traditionally considered low-risk and liquid as they invest in high-quality assets, including short-term Treasuries. Yet funds that rely on U.S. government debt could be a potential – though so far, unlikely – trouble spot if lawmakers are unable to hammer out a deal on raising the nation’s borrowing limit, setting the stage for a default.

HOW BIG ARE MONEY MARKET FUNDS?

Assets under management in U.S. money market funds, which include Treasury-only funds, prime funds, and government funds, totaled a record $5.2 trillion as of March 29, Investment Company Institute data showed.

The funds saw their third-largest ever monthly inflow in March, largely due to banking sector stress triggered by a run on deposits at Silicon Valley Bank, said Peter Crane, president of Crane Data.

Another reason for the funds’ growth has been their yield advantage over bank deposits. After the Federal Reserve raised its Fed funds rate target to 4.75%-5% over the last year, the average rate at money funds is 4.5% and trending toward 5%, compared to less than 1% for bank deposits, said Deborah Cunningham chief investment officer of global liquidity markets at Federated Hermes (NYSE:). WHAT IS THE DEBT CEILING?

The debt ceiling is the maximum amount the U.S. government can borrow to meet its financial obligations. When the ceiling is reached, the Treasury cannot issue any more bills, bonds or notes.

Some investors worry the Republican Party’s narrow majority in Congress could give the party’s hard-liners the upper hand, making it harder to reach a deal on raising the debt ceiling in 2023.

U.S. Treasury Secretary Janet Yellen has said the government could pay its bills only through early June without increasing the limit. Some analysts forecast that the government would exhaust its cash and borrowing capacity – the so-called “X Date” – sometime in the third or fourth quarter.

Legislative standoffs over raising the debt limit regularly occur in Washington and have largely been resolved before they could affect markets. A protracted standoff in 2011, however, prompted Standard & Poor’s to downgrade the U.S. credit rating for the first time, contributing to market volatility. WHY IS THE DEBT CEILING A CONCERN FOR MONEY MARKET FUNDS?

Though they are viewed as among the safest of investments, government officials and ratings agencies have recently warned that money market funds may be vulnerable to stress.

Fitch Ratings warned in February that the potential for investor redemptions and volatility in Treasury-only money market funds – as opposed to prime and government money market funds, which have other sources of funding – would rise if investors believed the government were to default.

“These funds could face increased volatility in the Treasury market and heightened investor redemptions as the debt ceiling deadline approaches,” the firm’s analysts wrote.

Yellen recently cautioned that money market funds are susceptible to runs on deposits during times of extreme market stress, as she called for stronger regulation of the growing non-bank sector.

Runs on money market funds have been rare. In 2008, a large money market fund that was over-exposed to commercial paper issued by failed bank Lehman Brothers suffered a run on assets, forcing its net asset value to fall below $1, a term known as “breaking the buck.” HOW ARE MONEY FUNDS MANAGING RISK? Some portfolio managers are avoiding Treasury maturities that could see volatility around the so-called X-date, after which the U.S. may no longer be able to pay all its obligations, said Crane of Crane Data.

Others are also looking to tap the Fed’s reverse repurchase agreement (RRP) facility rather than sell Treasury bills around potential technical default dates when volatility could rise, said Doug Spratley, who manages money funds for T Rowe Price (NASDAQ:).

The RRP allows money funds to buy securities from the Fed and then sell them back the next day at a higher price, ensuring liquidity.

“You don’t want to be a forced seller into that time, so you keep your liquidity high in something that’s not going to get hit, and the biggest, easiest answer is the RRP,” he said.

Over the past decade, the money fund industry has also put together working groups to prepare for the possibility of a technical default by the Treasury, said Federated’s Cunningham.