Citi's Rai on Implications of Reforms
Vikram Rai at Citi Research posted a piece, "Final Money Fund Reform: How Will It Affect Money Markets?." Writes Rai, "We expect inflows into govt. MMFs at the expense of institutional prime MMFs which will lead to less demand for credit products like CP, ABCP, CD, VRDNs and legacy repo. But since the compliance date for the floating NAV rule is more than 2 years away, this development is likely to play out slowly. Credit spreads on ultra-short term securities may widen slightly. However, regulatory pressure on banks to fund at longer maturities is likely to prevent bank commercial paper spreads from widening substantially. To the extent prime funds look to build liquidity in anticipation of potential outflows, prime funds may either increase investment in front-end Treasuries and repo (which could lead to wider credit spreads) or by reinvesting more in shorter maturity securities (which could lead to a steepening of the money market curve). As funds begin to comply, inflows into govt. MMFs could increase as some investors allocate out of floating NAV funds. Given the scarcity of investable short-term Treasuries, govt. MMFs could turn more to the Fed's ON RRP program; the usage of this program typically spikes during quarter ends and MMF reform would only add to the short term market's reliance on the Fed's program." He adds, "Currently the yield differential between institutional prime funds and institutional govt. funds is less than 2bp. But, an increase in this spread could incentivize corporate treasures and other investors to modify their guidelines such that they are able to invest in floating NAV funds and take advantage of higher yields. Additionally, short-term investors have shown flexibility and resilience when adapting to shocks in the past, for instance modifying AAA only mandates when US Treasuries were downgraded. Market participants have speculated that eligible investors could reallocate out of institutional prime funds into short duration funds, which offer higher yields. In our view, the majority of money fund investors, who look to liquidity and return of principal before the return on investment, are unlikely to transition to ultra-short duration funds. But those who are in a position to take on the added risk of short-term bonds continue to allocate a portion of their portfolios to this asset class in lieu of money funds. In the current environment, where front-end rates are priced lower than Fed's target rate and where the market expects rate hikes within the next 12–18 months, flows out of money funds and into ultra-short duration funds may be limited further."
