Money market funds hold firm; more hurdles loom

The U.S. debt ceiling crisis, S&P's unprecedented downgrade of America's AAA credit rating and eurozone debt woes have delivered a triple-whammy to money market strategies, but this time, the sector is proving resilient.

“For money market strategies, it's the biggest test since Lehman Brothers” in 2008, said Martyn Simpson, London-based senior associate within Mercer LLC's bond manager research boutique. “So far, they're holding up well” under redemption pressure.

Investors withdrew $148 billion, or about 5% of total net assets, from money market funds during the three weeks ended Aug. 2, the deadline for debt-ceiling negotiations, according to data provided by iMoneyNet, a money market research company based in Westborough, Mass. In comparison, about $16 billion was redeemed during the same period last year.

In the two weeks following Aug. 2, investors sought safety from turbulent global markets and returned to money markets — with inflows of about $88 billion.

However, money market fund managers still face several major challenges, said Viktoria Baklanova, New York-based senior director in the fund and asset manager rating group at Fitch Ratings Ltd. The low interest-rate environment already has made it very challenging for fund managers to operate profitably. In addition, the continuing regulatory debate over the structure of the money market sector is causing a lot of uncertainty. On top of that, there are far fewer investment options, particularly as recent market volatility has forced cash fund managers to shorten the duration of portfolios, which already are under more restrictive investment guidelines.

“Until these issues are resolved, it's difficult (for managers) to build a sustainable strategy,” Ms. Baklanova said.

Yields on money market funds have suffered. According to iMoneyNet, the simple seven-day average performance on all taxable money market funds was 4.77% on April 3, 2007, compared with 0.76% at the end of December 2008 and 0.03% at year-end 2010. The average seven-day yield as of Aug. 16 was 0.02%.

Pressure on short-term liquidity strategies was exacerbated by the congressional stalemate over negotiations to raise the debt ceiling in the U.S. and the subsequent downgrade by Standard & Poor's of the country's credit rating amid worsening eurozone economic weakness, sources said.

Christopher Redmond, London-based senior investment consultant in Towers Watson & Co.'s cash manager research division, added: “If cash funds struggle, and by implication short-term funding markets are challenged, the outcome would likely be horrific.”

At J.P. Morgan Asset Management, for example, managers in July stopped investing in assets that matured beyond Aug. 2. “We were building liquidity” and had anywhere between 40% and 75% of the money market fund assets invested in overnight positions, said John T. Donohue, managing director and chief investment officer of global liquidity at J.P. Morgan Asset Management in New York. JPMAM had about $450 billion in money market assets under management as of June 30.

“The difference is that managers have learned that you're really protected by your (portfolio) maturity,” said Joe Sarbinowski, managing director and head of institutional liquidity management at DB Advisors in New York, which manages about $120 billion in money market strategies. “For example, it's not uncommon for us to have between 40% and 50%” invested in securities with a maturity period of seven days or less, he said.

Money market funds domiciled in the U.S. accounted for about $2.5 trillion, or about 55% of the total worldwide, as of June 30.

Following the collapse of Lehman Brothers Holdings Inc., investors fled cash funds, many of which held illiquid assets and could not meet redemptions. The Federal Reserve had to step in with a temporary funding facility, and managers spent billions propping up money market funds. In 2010, new regulations required money market funds to hold at least 10% of their net assets in overnight securities and 30% in debt that matured within seven days.

Eurozone problems also have made cash managers more nervous. Most have scaled down allocations to short-term debt issued by European banks, which typically have higher exposures to regional sovereign debt in troubled nations including Italy and Spain.

French banks — chiefly BNP Paribas SA, Societe Generale SA and Credit Agricole SA — were hit the hardest, making it more difficult for them to borrow U.S. dollars through money market funds, said Peter G. Crane, president and CEO of Crane Data LLC, Westboro, Mass., a research firm that focuses on short-term liquidity strategies. Still, French banks are still among the top 10 holdings of prime money market funds accounting for about 7.3% of the total assets, according to Crane data.

“U.S. money market funds and French banks couldn't leave each other even if they wanted to,” Mr. Crane said. “French banks continue to be among some of the most highly ranked financial institutions in the world, and (cash fund managers) need to diversify exposure.”

While investors remain confident in French banks from a fundamental standpoint, there's a matter of headline risk, managers said. At Legg Mason Inc., the money market team “has significantly diminished its exposure to eurozone banks recently because of headline risk, not because of credit issues,” according to a statement from the firm. Legg Mason has about $110 billion in liquid assets under management, including money market funds.

At Vanguard Group Inc., cash fund managers began reducing exposure to European banks in 2010, said David R. Glocke, Malvern, Pa.-based principal and head of taxable money markets. Vanguard's cash fund managers not only stopped investing in troubled nations such as Italy and Spain, but also France and Germany because of uncertainty surrounding the cost of bailing out indebted countries in the eurozone.

“We redeployed (assets) to other sectors, including Treasuries and (U.S.) agency securities, as well as Canadian and Australian banks,” Mr. Glocke said. Vanguard's money market strategies — including its $114 billion Prime Money Market Fund — also increased their holdings in commercial paper issued by household names such as Nestle SA, The Coca-Cola Co. and PepsiCo Inc., Mr. Glocke added. As of July 31, Vanguard had $152 billion in money market strategies.

Earlier this year as concerns over the stability of the European banking system heightened, U.S. prime cash funds cut exposure to eurozone banks by $58 billion in June and $38 billion in July, according to a research paper published Aug. 9 by J.P. Morgan Chase & Co. However, eurozone banks still account for about 32% of the total assets invested in prime money market funds.

“By nature, (cash managers) need to select bonds that are highly rated, and there are just not many traditional companies that are as highly rated as banks,” Mercer's Mr. Simpson of Mercer said, “so there's a massive slant toward banks.”

Cash funds' exposures to European banks had been moving higher following the Lehman Brothers collapse, partly “as a function of the deterioration of U.S. bank credit,” but recently have started to come down because of fragility in the eurozone, J.P. Morgan's Mr. Donohue said.

David Rothon, senior vice president and fixed-income product specialist at Northern Trust Global Investments in London, said investments in short-term debt issued by European banks now account for between 10% and 20% of money market portfolios compared with between 30% and 40% a year ago. Mr. Rothon, whose firm manages about $100 billion, added: “The biggest threat to money market funds is still old-fashioned liquidity.”