Yesterday, we reported on Fitch Ratings stable outlook for money market funds in 2015. (See Monday's "News," "Money Fund Outlook Stable for 2015, Says Fitch; New Products, Global). Moody's, however, came out with a slightly different take on 2015, issuing a negative outlook for money market funds next year with its publication, "2015 Outlook - Money Market Funds: Market Challenges Underpin Negative Outlook." Moody's explains, "Moody's has revised its outlook for money market fund ratings to negative from stable. The change in outlook reflects our expectation that 2015 will be an inflection point where, despite cautious investment approaches, MMFs will struggle to maintain the highest credit and stability profiles in the face of an ongoing supply-demand imbalance, low to negative fund net yields, and elevated asset flow volatility." Below, we excerpt from Moody's European-centric outlook, which focuses on supply, regulations, and interest rates.
Among its projections, Moody's expects the number of Aaa-mf funds to drop. They write, "MMFs will continue to face an unstable market environment with an ongoing supply-demand imbalance, potential divergence in global monetary policies, reduced secondary market liquidity, an expected increase in investor flow volatility and increased transition risk in global bank ratings. The combination of these factors should weaken funds' Credit and Stability Profiles under Moody's MMF methodology, and challenge MMF's ability to mitigate these pressures through active management. MMF managers' commitment to maximize fund yields in a historic low interest rate environment results in increasing extension of portfolios' maturities. A barbell strategy involves investing a large proportion of portfolio assets in longer-dated securities to generate higher yields, while offsetting these riskier investments with short-dated high quality securities."
Moody's explains, "MMF managers may also achieve this balancing act by lowering portfolio credit quality, but our data shows that this has not been the case so far, as credit quality in Moody's-rated MMF has generally improved over the last 12 months. Despite improvements in overall portfolio credit quality, higher percentages of longer-term investments and a reduction in availability of Aaa-rated securities have elevated exposure to market risk. This trend is clearly highlighted by the evolution of Euro MMF stress NAVs, which hit their lowest level in 12 months in Q3 2014. This negative trend would be further exacerbated in 2015, in case of further deterioration in portfolio credit quality, for example in the event of credit pressures in the banking sector."
Further, they comment, "[A] shortage of high quality short-term investments may drive greater risk-taking in MMFs. Rising investor demand globally for high quality short-term (overnight to 60 days) investments, combined with regulatory disincentives for financial institutions to rely on wholesale short-term funding will keep availability of money market supply tight, according to estimates from J.P. Morgan, and short-term rates floored."
Moody's speculates, "Tighter supply conditions for the highest quality short-term investments will push MMFs to extend their investment tenors in pursuit of yield and capacity, and potentially move down in credit quality in pursuit of the same. MMFs that pursue longer tenor and lower quality investments increase the fund's susceptibility to liquidity risk, a credit negative. We believe the severity of this risk has increased in the current market environment where availability of secondary market liquidity is an emerging concern due to the significant declines in broker-dealer security inventories."
They add, "Alternatives to direct bank obligations also remain limited. Non-financial commercial paper outstanding volumes have increased, but volumes are still relatively small. Similarly, asset backed commercial paper (ABCP) outstanding volumes are likely to remain depressed, as new regulations reduce the attractiveness for banks to finance assets through ABCP conduits."
Moody's Outlook continues, "In the US, the Fed's overnight reverse repo facility (RRP) and its newly announced term RRP facility will continue to be a temporary relief valve for eligible government and prime MMF counterparties against ongoing supply-demand imbalances.... While the new $300 billion aggregate facility cap reduces the utility of the facility at quarter-ends, the facility is only going to grow in importance for government MMFs, as new MMF reforms drive assets from prime funds into government MMFs. The end of QE in the US will also provide some supply benefits in 2015. On top of the ongoing supply-demand imbalance, gradual deterioration in banking system credit profiles will continue to create additional supply challenges. Further, in September, Moody's announced proposed changes to its bank rating methodology, which, if adopted, would likely impact eligible supply levels, as the proposed changes are likely to result in changes to banks' deposit and senior unsecured ratings."
On interest rates, Moody's comments, "Monetary policy normalization in the US and the UK and ECB's accommodative monetary policy will drive down MMF balances. While we expect monetary policy normalization to begin in the US and the UK, the timing and pace of policy normalization will be highly dependent on economic conditions. Following initial rate hikes, US and UK MMF balances are likely to fall, as MMF yields temporarily lag market yields on direct investments. As MMF yields catch up, MMF balances will rise consistent with previous tightening cycles, but not to the same degree, because US MMF reforms have made prime funds less attractive investments, and the supply-demand imbalance keeps government MMF yields floored."
They write, "In Europe, the ECB's accommodative monetary policy will continue to weigh heavily on short-term rates. Extremely low to negative fund net yields may become the new normal for Euro MMFs. While some Euro-denominated government MMFs started posting negative net yields in November, we expect net yields on Euro prime MMFs to continue to trend downwards, and they may turn negative for some prime funds in 2015. This will force Euro MMF investors to choose between paying for MMFs' safety and liquidity or investing in positive yielding alternative products featuring lower liquidity and/or riskier credit profiles. While many investors will stay put prioritizing safety and liquidity over yield, we expect a rise in outflows in 2015, as other investors show little appetite to stomach negative yields. In response to investor behavior, Euro MMF managers will feel greater pressure to increase credit and/or duration risk in funds, in order to generate positive yields, in some cases pushing the boundaries of key MMF rating factors."
Regulations will make MMFs less attractive liquidity options, says Moody's, concluding, "New US MMF reforms represent the biggest changes to the MMF product characteristics since the inception of MMFs in the 1970s.... These changes forever alter two of the qualities -- convenience and liquidity -- that investors found most attractive in MMFs as cash management products. While we have seen few signs of reform-related outflows from institutional prime MMFs to date, we expect outflows to accelerate through 2015 and into 2016, when the rules are scheduled to be implemented. Sweep account clients are likely to be among the early movers, as they have indicated that liquidity fees and redemption gates are major obstacles to product acceptance."
Finally, they say, "Government MMFs are a likely reinvestment choice for investors redeeming money from prime MMFs, but expectations that the rush of new money may worsen the supply-demand imbalance may make them a less attractive option. Alternative liquidity products such as separately managed accounts (SMAs), enhanced cash funds, ultra- and short-duration bonds will also be in higher demand, as cash investors seek to define the "new safe" liquidity products. All in all, we would not be surprised to see reform-related outflows exceed 25% of total AUM of institutional US prime funds between now and 3Q 2016 when the rules will be implemented. While it is impossible to determine when the European regulation on MMFs will be finalized, it seems that one of the key proposals initially made by the Commission -- to impose a 3% capital buffer on CNAV funds -- is strongly contested by fund managers. We therefore expect to see the future European MMF rules to combine principles of the initial proposal with some principles similar to the new US rules, such as floating NAV for prime funds held by institutional investors."
