Challenges Facing Government Money Market Funds by John McColley, ColumbiaManagement
- Investors with no risk tolerance or who need stable $1 NAV will likely gravitate towards government money market funds. Such funds may provide peace of mind and liquidity, but will be challenged to offer a competitive yield.
- Investors seeking a higher yielding product may look to combining a government money market fund with one or more floating NAV retail funds.
- It will be up to individual investors to determine their needs for cash investments and to select the investment products that best fit those needs.
Co-authored by Alice Flynn, Senior Product Manager
Six months have already passed since the SEC approved sweeping money market reforms to Rule 2a-7. However, most firms have yet to make a final decision on what money market products to include in their investment lineup come October 2016. Unlike the changes instituted in 2010 where fund managers had time to allow portfolios to shorten weighted average maturities naturally, these new changes will be much more disruptive to both investors and issuers in the short term markets.
The cost to implement these new regulations (800+ pages of reforms) may prove to be prohibitive for smaller funds, with some firms already waiving the white flag. For those still working through the systems/process changes and website modifications, a conundrum exists. Firms want to convert to the products that will be most desirable to their shareholders, but shareholders don’t know what they want yet and are waiting to see what will be available. With time on the side of the investor, those firms that want to continue to be in the money market business are considering all options to retain and gather assets.
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Since the beginning of money funds in the 1970’s, three types of money market funds have existed – retail, institutional, and government – with relatively minimal differences between them. The prospect of earning a higher yield in a money market fund than an FDIC insured bank account has had widespread appeal. Investors have poured trillions into money market funds, breaking the $1 trillion barrier in 1997. (Exhibit 1), confident, though not guaranteed, that they would get it back with interest on demand. Now the prospect of a floating NAV for institutional funds, and the uncertainty surrounding redemption fees and liquidity gates for all but government funds leaves investors questioning whether their cash will actually continue to be cash. As the industry and investors grapple for the right formula, billions of dollars will be in flux.
Government money market funds
On the surface, this option appears to be the easiest solution for mutual fund families to implement and the structure of the fund will remain the closest to what investors are familiar with. However, government money market funds have been newly defined as investing 99.5% of their assets in cash, government securities or repurchase agreements that are fully collateralized. Shareholders will continue to use a stable $1 NAV and won’t need to worry about redemption fees or liquidity gates. Fund families that change their institutional funds to government funds will also be able to retain the existing shareholder base as both natural persons and institutional investors can remain in the fund together. How can the SEC allow this commingling of investors, especially should there be a liquidity run on the fund? The SEC’s rationale is that historically there has never been a problem with the liquidity of government money market securities.
Unfortunately, it is not possible or logical for all institutional or retail money market funds to convert to government money market funds, given so many variables and challenges that exist. A breakdown of money market funds by assets and number of funds in each category are provided as Exhibits 2 and 3.
Exhibit 2 and 3
Source: IMoney Net as of 12/31/14
Supply of eligible investments
According to iMoney Net, there was $2.75 trillion in money funds as of December 31, 2014. At the same time, the September 30 available supply of short government paper totaled about $3.8 trillion, with roughly $1.5 trillion in T-Bills, $1.25 trillion in Treasury notes and bonds within one year of maturity, and an additional $1.1 trillion* in qualifying agency securities. Should budget deficits decline, Treasury issuance will most certainly decline as well. Additionally, ICI reported that “as of June 2014, taxable money market funds held just $377 billion – or 13 percent – of short-term debt issued by the Treasury”. The remaining supply of these securities is already owned by central banks, state and municipal governments, commercial banks and existing separate cash accounts. Even as the Fed begins to raise rates, the added demand from government money market funds to a potentially shrinking investable universe will cause spreads to widen and government securities to yield less than other money market securities.
Within the Government Agency category, Federal Home Loan Bank (FHLB) has been a big issuer of debt but there is uncertainty whether Fannie Mae and Freddie Mac, both big agency issuers of agency discount notes, will continue to exist.
There is also a question as to the long term access to the Fed’s ON RRP (Overnight Reverse Repo Program). Usage typically spikes during quarter ends and the new money market reforms are expected to add to the short term market’s reliance on this program as the scarcity of investable short-term Treasuries generally drives the importance of the RRP. If the Fed were to end the program, a reliable supply of government securities would be significantly impacted. Market participants have also speculated that an aggregate cap could be imposed on the facility, thereby restricting the supply of government securities when there could be increased demand.
Limited yield potential
A government money market fund’s inability to invest in spread products – CP, ABCP, CD, VRDNs and legacy repo – will limit the yield and total return potential. Government securities are already limited in their return potential given the additional yield that these other security types generally offer (in exchange for higher risk). Also, increased demand for Treasury and Agency securities will drive their prices higher and reduce the yield potential of the government securities even more.
In addition, government money market funds will still not be allowed to invest in Tier 2 securities, which the other money market funds are able to buy. The removal of the credit rating requirements in Rule 2a-7 is expected to benefit the Tier 2 securities market and ultimately the money market funds that will be able to invest a higher percentage in this category. Historically, institutional and retail money market funds were only allowed to invest up to 3% of their total assets in Tier 2 securities.
Expanded list of investment options to compete with
According to Peter Crane, president of Crane Data, a research firm that tracks money market funds, “the general consensus is that the big players in the money market industry are going to be prepared to offer all three types of money market funds, as well as develop other products where they see potential asset growth.” Additional products under consideration for those investors looking for more yield and to avoid fees and gates include short-term bond and ultra short-term bond funds, private funds, expanding separate accounts business, and Federated is considering a 60-days and under maturity product, which keeps it under the SEC’s money market reform radar.
What does the future hold?
There will always be a long-term need for short-term assets, whatever one’s investment style. Investors with no risk tolerance or who are required by regulatory guidelines or investment constraints mandating a stable $1 NAV will likely be the ones who gravitate towards government money market funds. Such funds may provide peace of mind and liquidity, but will be challenged to offer a competitive yield.
On the other hand, Investors seeking a higher yielding product may look to diversify their investments between multiple funds. Combining a stable $1 NAV government money market fund with one or more floating NAV retail funds may help investors increase the likelihood that the cash they may need will be available when they want it, should one or more funds be impacted by fees and gates.
Whatever the flows may be in the category, it will be up to individual investors to determine their needs for cash investments and to select the investment products that best fit those needs.
*SIFMA, September 30, 2014