Moody's Investors Service published a "Special Comment" yesterday entitled, "Money Market Funds: Decline of Eligible Assets Raises Challenges." The publication's "Summary Opinion" says, "Since 2007, prime money market fund (MMF) managers have seen a consistent decline in their short-dated, high-quality eligible investment universe. This follows three supply side developments: (i) a decline in product availability due to dislocations in the short-term structured securities market; (ii) reduced short-dated issuance from key sectors, namely financial institutions, due to official policy measures, regulatory developments and credit quality declines; and (iii) regional liquidity pressures that exacerbate relative supply challenges, predominantly for Euro-denominated MMFs. On the demand side, MMFs face more stringent regulatory requirements which limits investment flexibility, especially with respect to maintaining adequate liquidity in overnight and short-dated securities. Overlaying this constraint is the addition of further self-imposed limits that MMF managers maintain to mitigate against the risk of not satisfying investor liquidity demand."

The Moody's piece, written by VP & Senior Analyst Michael Eberhardt, continues, "The decline in the overall volume and number of eligible issuers presents a real challenge to maintaining a diversified investment portfolio. In our view, this challenge is manageable, provided MMF managers are willing to forego yield in pursuing recent increases in issuance of higher credit quality assets. Short-term money markets have actually seen a rise in issuance from several sovereign and supranational agency issuers, creating an opportunity for MMFs to increase their portfolio credit quality."

It explains, "At the same time, several credit positive trends are emerging in the MMF sector, such as (i) the intensified pursuit of various forms of collateralised lending (repurchase agreements backed by Aaa-rated sovereign debt); and (ii) investment in legacy covered bond issuances that provide a source of diversification and market pricing benefits. We also observe there is longer term potential for increased corporate commercial paper (CP) issuance. Top-tier corporates are able to issue cost-effective CP, which would provide a source for MMFs to diversify and reduce further their overweight exposure to financial institutions. We believe that these trends could partially offset the challenges to the MMF sector described above, though the overwhelming reduction in supply of qualifying assets will remain a real issue for the sector well into 2012."

Later in the piece, Moody's comments, "Consistent with the pursuit of quality, fund managers are also pursuing various forms of collateralised lending. The use of repos backed by Aaa-sovereign collateral has enabled funds to provide liquidity to counterparties with the reassurance of having access to high quality collateral in the event of a counterparty default. Figure 5 highlights the increasing use of repos in the representative U.S. prime MMF segment."

They write, "A final theme to highlight is our anticipation of increased corporate CP issuance over the longer term horizon. The extent of excess cash balances maintained by top-tier corporates would suggest corporate CP as an unlikely outlet for growth in CP supply in the near term. This may change as corporations consider dividend increases and look to renegotiate their short-term borrowing and revolving credit facilities."

Finally, Moody's says, "Historically, corporations have funded their working capital needs through lending facilities arranged with their relationship banks. Given regulation and the increase in capital costs by financial institutions assuming this credit risk, the roll-over of bank credit facilities may be on terms inferior to those available via the CP market. This dynamic, along with the attractive funding levels being achieved by top-tier corporates, sets up an environment supportive of increased supply of corporate CP on a longer term basis. In our view, this would be a credit positive for MMFs by allowing funds to diversify away from their overweight exposure to financial institutions."

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