Ultra-short funds see opening in money market reforms

The past year has seen investors pull more than half a trillion dollars from prime money market funds, leaving asset managers scrambling to react. What once was a $1.79 trillion industry has shrunk by more than a quarter, drawing demand from commercial paper markets and pushing up short-term rates. If prevailing opinion is right, the outflows are far from over. But for some this so-called ‘Big Shift' is an opportunity they have long been waiting for.

The trigger for the exodus has been the Securities and Exchange Commission's (SEC) 2-a7 money market reforms due to come into effect on October 14.

The changes affect prime and municipal cash-exempt money market funds but not their government counterparts. Prime funds are required to set a floating net asset value (NAV) for institutional investors instead of the traditional fixed $1 and will be able for the first time to impose gates or fees if facing a redemption run. As a result government funds have swept up much of the outflows, with assets growing from $1.02 trillion to $1.59 trillion over the period.

Over the past few months, money market fund managers have scrambled to reposition themselves ahead of the October deadline, in many cases converting existing prime funds into government funds to avoid the claws of the reforms.

But some asset managers – Pimco, for example – see opportunity in the collapsing prime sector and in the cascade of effects it is having across short-dated markets.

"We have been anticipating money market reform for more than two years," says Jerome Schneider, portfolio manager and head of Pimco's short-term and funding desk in Orange County, California. The firm has been "opportunistically" positioning its short-term capital preservation strategies to benefit, he says.

Since April, the total number of institutional and retail prime money market funds has fallen a quarter, from 504 to 379, while the number of government money market funds has risen 12% from 575 to 645, according to data from industry body the Investment Company Institute.

It was prudent to convert our prime funds to government money funds
Ira Jersey,Oppenheimer Funds

"Many of our investors don't want products with gates and withdrawal fees or a floating net asset value (NAV) and don't want to deal with these new regulations, so it was prudent to convert our prime funds to government money funds," says Ira Jersey, senior client portfolio manager at Oppenheimer Funds in New York.

Renuka Kumar, senior portfolio manager at SVB Asset Management in San Francisco, expects another $300 billion to $400 billion to shift. "[Prime funds are] not a suitable cash vehicle anymore," she says.

Demand shortage

The effects are stark. As money funds shy away from commercial paper, a huge portion of demand has been removed from the market.

"Prime fund managers have to be very conservative in managing the duration of their funds, and they are maintaining a tremendous amount of liquidity to protect against potential drawdowns," says Jerry Klein, managing director of HighTower Treasury Partners in New York.

The mean weighted average maturity (WAM) of prime funds is now 24.8 days and the mean weighted average life (WAL) is 39.8 days, according to data from the SEC. WAM was 29 days and WAL 56 days at the end of September 2015, according to data provider Crane Data.

As a consequence, banks and other issuers of financial commercial paper are being forced to raise rates to attract buyers. Three-month AA commercial paper rates have jumped from 55 basis points to 72bp over the same time period, for example.

In turn, hiked borrowing costs for banks have led to a rapid increase in three-month dollar Libor, hitting a seven-year high of 83bp in August, from 62bp on June 24.

Non-money market managers have long been expecting such a move. "It's gotten attention because the spot Libor moved, but the forward market has priced [for this] for much of this year. If you look at forward rate agreements they were generally pricing for us to get to 80bp in mid-September in Libor," says Oppenheimer's Jersey.

In the past, non-money market funds typically shunned commercial paper. Now, they are stepping in to take advantage of higher yields. "A year ago you were probably looking at 35bp on commercial paper and now it's increased to around 1% in a six-month time frame," says SVB Asset Management's Kumar, whose firm holds 20-40% of commercial paper in its separately managed corporate cash accounts. That compares with a year ago when the exposure was "very minimal", Kumar says.

For almost a year we have been actively positioning our clients' portfolios for increased exposure to Libor-benchmarked assets
Jerome Schneider, Pimco

Pimco, meanwhile, is boosting allocations to floating rate assets indexed to Libor such as senior corporate debt and some structured products. "For almost a year we have been actively positioning our clients' portfolios for increased exposure to Libor-benchmarked assets," Schneider says.

Oppenheimer, too, sees opportunity – primarily in senior loans, non-agency mortgages, and agency and non-agency collateralised mortgage obligations – but Jersey says there are still obstacles to overcome.

"The senior loans have three-month Libor floors at about 75bp so some of those will start resetting with slightly higher coupons. But the majority of senior loans don't reset until 1%, and I don't think we'll get to 1% just because of the reforms.

"With non-agency mortgages and CMOs [collateralised mortgage obligations] the coupons will go higher, but people will be incentivised to refinance if they go much higher. Again I don't think rates have gone up enough to force that," Jersey says. "At the margin, things that float based on Libor seem more attractive but it's not a home run."

Meanwhile, the convergence of yields on commercial paper and corporate bonds has undermined some popular trades.

"It always used to be that a high-grade issuer with good fundamentals would issue six-month commercial paper at 50bp but might also have an old five-year bond with six or seven months to maturity that might yield 70bp because it would be less liquid. We could take advantage of that differential and pick-up spread. Some of that is going away now because of what's going on in the short-term funding markets," Jersey adds.

How long will opportunities last? "There's been a yield advantage for quite some time in this strategy but people haven't been looking for it until now," says Christina Kopec, head of product strategy for global fixed-income and liquidity solutions, third-party distribution at Goldman Sachs Asset Management in New York. "On a one-year basis, we have a 74bp return versus… a 25bp range in government money market and 40bp in prime. We are probably in the sixth or seventh inning out of nine in terms of adopting this strategy in the market."

Short-term potential

One possibility would be that ultra-short-duration bond funds (USBFs), launched by several asset managers in recent years to take advantage of 2-a7 reforms (see box, Short-term thinking) might replace prime fund demand. But the shortfall far outstrips their capacity at present.

"We've seen over $500 billion in outflows from prime and tax-exempt funds into government. From an absolute perspective that's an enormous amount… and a pretty large gap to fill for some banks and short-term commercial paper issuers relying on the short-term wholesale funding markets," says Peter Yi, director of short-duration fixed-income at Northern Trust in Chicago.

"The USFI [ultra-short-duration fixed-income] market is dramatically smaller than the registered money market business. It is only about $72 billion so it's just a drop in the ocean relative to the $2.7 trillion money market mutual fund industry." In fact, net assets for USBFs were $72.7 billion in August down from a peak of $77.6 billion in November 2014, according to Morningstar.

SVB Asset Management's Kumar says: "New investors like us and short bonds funds could contain the spread-widening but it's not enough to account for all the demand 2-a7 funds provided."

A second possibility is that higher funding costs might lead to a drop in commercial paper issuance, especially as Basel III reforms pressure banks to reduce dependence on riskier shorter-term funding.

Non-seasonally-adjusted commercial paper issuance declined from $514.6 billion in March to $490.6 billion in August, according to data from the Federal Reserve.

"The typical money market fund was writing 30-day, 60-day and 90-day commercial paper with banks but the liquidity coverage ratio (LCR) rules in Basel III make it punitive for a bank to write 30-day commercial paper with a money market fund," says Joe Lynagh, short-term bond fund portfolio manager at investment manager T Rowe Price in Baltimore.

Banks have to hold high-quality liquid assets, so the rules have pushed these two traditional parties apart
Joe Lynagh, T Rowe Price

"Banks have to hold high-quality liquid assets, so the rules have pushed these two traditional parties apart. Banks, in particular, are being forced to seek longer-dated funding such as issuing three-year bonds, which is a natural offering for an ultra-short-term fund."

Even if rates do recalibrate, the process seems likely to be slow. "I wouldn't expect yields to go back to levels seen earlier this year as soon as the money market reform is implemented in October," Pimco's Schneider says, predicting a process of "months or quarters" for rates to fall back.

Meanwhile, at HighTower Treasury Partners, Klein thinks prime money markets will be in a better position to attract investment by 2017. "The prime fund managers are going to want to be very conservative and maintain liquidity inside of their funds. However, as we move into 2017, they'll likely be in a better position to extend their maturities and earn spread versus government money market funds," he says.

Yet, even if prime money market funds recover some of their yield differential relative to government funds next year, the notion of money market funds as risk-free has been debunked. With investors starting to rethink their approach towards cash, 2017 might be the year that ultra-short duration fixed income strategies really start to see asset growth.