New rules requiring floating net asset values and potential withdrawal restrictions on institutional prime money market funds won't take effect until October 2016, but some money managers and consultants are warning the time to move out of them is now.
Among the issues with delaying, they warn, are the potential for investment losses and reduced liquidity from a last-minute rush to the exits that could negatively affect the nearly $1 trillion of assets now in institutional prime funds.
“I understand why some people might have the perspective that it's too early. ... But it's not too early to have these conversations,” said Kimberly Gillett, manager research analyst-U.S. fixed income, Towers Watson & Co. LLC, New York. “Decisions will need to be made, and if you can already make the change to Treasury and government money market funds, it's an easy change to make.”
Prime funds are popular tools for pension funds, endowments and foundations, and custodians for cash sweeps and short-term transitions for rebalancing; they're seen as highly liquid with a set $1 NAV. But on Oct. 14, 2016, Securities and Exchange Commission rules will require floating NAVs on institutional prime money market funds, and the boards of money market funds will be allowed to impose fees and restrictions on investors that want to withdraw funds in times of financial crisis.
Retail prime funds will keep the fixed $1 NAV but their boards will be allowed to impose the same fees and restrictions as institutional funds; government money market funds will have the fixed NAV as well, but will have no fees or restrictions.
Sources at money market fund managers interviewed for this story agree there's been no exodus by institutional investors.
“In the institutional prime market, there's about $900 billion now, about the same as in July 2014” when the SEC approved the rule change, said Thomas Callahan, managing director, co-head of BlackRock (BLK) Inc. (BLK)'s global cash management group, New York. “There's been a lot of talk about a grand shift from prime to government funds, but industry flows haven't indicated that it has happened — yet.”
Brandon Swensen, senior portfolio manager, co-head of fixed income at RBC Global Asset Management (U.S.), Minneapolis, argued that now's the time to make the change as the maximum allowable maturity for securities in prime funds is 13 months. “We're at 13 months before the regulations take effect, so the composition of prime funds means that people should act now,” Mr. Swensen said. “There's no perception of any risk before October 2016. ... But through time, as more money moves, there could be dislocation, a large-scale liquidation of securities at the same time. That could cause some potentially serious problems.”
Bud Person, executive vice president, wealth management and cash division, Federated Investors (FII) Inc. (FII), Pittsburgh, said the shift in assets to government from prime funds could affect spreads. “We do think with any meaningful shift, a couple hundred billion dollars or more, that you could see as a result that spreads would widen. It's just supply and demand. If you have some investors selling out of prime funds and into government funds, government yields will stay lower and prime yields could go up.”
That could make prime funds attractive even with a fluctuating NAV, said Mr. Person, “so you may have some institutional investors staying with prime funds despite the new rules. Those fluctuating NAV prime funds could have the potential to outperform certain government funds in certain time periods and circumstances. Institutions will have to look at prime funds not just with their yield but on a total-return basis.”
Declining yields of government money market funds could make them off limits to many pension funds whose investment committees have limits on how low yields on approved investments can go, said Robert Zondag, co-managing partner, American Deposit Management LLC, Delafield, Wis.
“Many committees have investment policies that limit what they can use from both yield and safety perspectives,” Mr. Zondag said. “Such constraints could limit their options, especially close to the October (2016) date.” ADM is an institutional cash manager with about $5 billion in AUM.
'3 powerful market currents'
BlackRock (BLK)'s Mr. Callahan said that money market reform is one of “three powerful market currents colliding simultaneously,” along with the ramifications of Basel III banking regulations and future changes in the Federal Funds rate.
He said hundreds of billions of dollars being pushed by banks to government money market funds because of Basel III “could aggravate the shortage of government collateral and make government funds more expensive.” Also, the yield premium in institutional prime funds relative to government funds will be partially determined by the level of the Fed Funds rate. “Right now that spread is about 12 basis points,” Mr. Callahan said. “Is that enough premium to move from a (constant NAV) government fund to a (fluctuating NAV) prime fund? Probably not. But if rates go up, is 20 basis points enough compensation? 30? 50?”
Those uncertainties, not any foot-dragging, are the real reason asset owners aren't acting, Mr. Callahan said. “Those concerns make institutions uncertain, and when they're uncertain, they watch and wait. That's what you're seeing now.”
Mr. Swensen of RBC Global and Towers Watson's Ms. Gillett both warned that another unintended consequence of the new rules could be what Ms. Gillett called a “potentially interesting scenario” involving overall corporate bond liquidity. “There are definitely issues concerning liquidity if everyone tries to move assets all at the same time,” she said.
“There's an indirect aspect of this that's difficult to quantify, but there is linkage” between a large outflow from prime funds and corporate bond liquidity, Mr. Swensen said. “Prime money market funds are a sizable holder of corporate bonds. That will significantly shrink as a result of the outflows, and a sudden rush (to) exits could have a negative effect on corporate bond financing. Corporate bonds will price lower liquidity into spreads (on the secondary market). The sudden shrinking of prime money market funds will be another direct hit on corporate bond liquidity.”
However, Messrs. Person and Callahan disagreed, saying liquidity won't be an issue. “The repo markets are contracting rapidly, a lot of issuers are terming out their short-term debt, and Treasury bill supply is shrinking,” Mr. Callahan said. “With large demand and limited supply in the front end, we are confident liquidity will be substantial for prime funds.”
Peter Yi, senior vice president and head of short-duration fixed income, Northern Trust Asset Management, Chicago, said he expects institutions to make the move from prime funds starting early next year.
“It all depends on what's the right liquidity solution,” Mr. Yi said. “If a balanced solution exists today, then we encourage them to move when they are ready. If not, we want to start working with them now to think about all the enhancements they think they need to improve their liquidity management experience. ... I'd say in early to mid-2016, we think that's a good time frame to conclude our final discussions and put this all together with thoughtful recommendations.”
This article originally appeared in the September 21, 2015 print issue as, "Don't delay moves on money market, investors warned".