The big news last week that Fidelity plans to convert three of its prime funds to government funds has left many wondering about the implications and possible ripple effects, including industry strategists Joseph Abate from Barclays and Vikram Rai from Citi Research, who shared their perspectives this week. Fidelity announced last Friday that it was reorganizing some of its money market funds in response to investor demand and recent money market reform. (See our News stories, "Fidelity Announces Major Changes to MMFs; Staying Stable, Going Govt" and "NY Fed Alters Fed Funds, Adds Funding Rate; More on Fidelity Changes.") Fidelity plans to convert three of its prime funds to government funds late this year, including the $112 billion Fidelity Cash Reserves, the world's largest money fund, and merge several other MMFs. (Note: Fidelity hasn't commented on plans for its Institutional money fund lineup yet, but we expect some kind of statement reaffirming the firm's commitment to "prime" later this week.)
In his commentary, "Change of Status," Barclay's Joe Abate said one of the impacts is that it will raise bank unsecured funding costs and push bill and government repo rates lower. He writes on the pre-Fidelity announcement environment, "Despite the prospect of unpopular reform, money fund investors in prime institutional funds have not begun leaving for stable value alternatives. Instead these balances are about 7% higher than their May 2014 level. Flows into institutional government-only funds have been stronger, but without a decline in prime fund balances it is difficult to see evidence that money fund investors are re-allocating to avoid upcoming regulations. In the absence of any investor flight, money fund managers have made few changes to their portfolio composition or the maturities of the securities held. Prime institutional money funds hold about 60% of their assets in bank-issued CP and CDs."
He adds, "However, it seems that if prime funds were worried about a potential mass departure of investors to stable NAV alternatives, they would have reduced their holdings of bank paper by letting them roll off and increasing their government repo and debt positions. Clearly this could still occur, but it seems that the initial industry reaction has been to take an overtly wait-and-see attitude."
Abate continues, "This seeming "business-as-usual" attitude got a rude shock late last week. Managers of the largest US prime money fund announced plans to convert into a government-only fund pending a shareholder vote in March. Two other much smaller funds will also convert to government-only funds. The three funds together have just under $130bn in assets under management. And, like the industry in aggregate, these funds' holdings are concentrated in bank unsecured paper such as CP and CD. They hold roughly $100bn of this paper -- or 75% of total assets. The remaining assets are split across repo and government debt -- largely held to meet the SEC's overnight and 7d liquidity buffer requirements. Their Treasury repo holdings (just $3bn at the end of November and a bit higher at the end of December) are exclusively with the Federal Reserve as counterparty."
Abate goes on, "The fund managers of these three funds face a difficult task over the next 6 [months]. They will need to divest their holdings of everything other than government debt and repo backed by government debt. Assuming these funds adopt the average asset allocation of the typical government-only money fund, they would need an additional $35bn and $43bn in Agency and Treasury debt, respectively. They would also need to source an additional $11bn and $27bn in Agency and Treasury repo, respectively."
He adds, "Finding an adequate supply of replacement government debt could be difficult. First, the Treasury is set to issue fewer bills this year. And while the supply of short-term (under 397d) Treasury coupon debt is roughly equal to the total amount of outstanding bills, nearly all this supply is locked up by final investors and is unlikely to come back into the market before maturity.... Second, as is apparent in the recurring quarter-end crash in money fund repo holdings, securing bank repo is getting more difficult as balance sheet pressures push banks to ratio the supply of collateral. We think that divesting their bank obligations will be much easier. Given the maturity of this paper and their desire to complete the conversion by the end of 2015, we expect these funds will start letting their CP, CD, and other unsecured bank obligations roll off at maturity."
Further, "The size of the asset re-allocation ($100bn) is probably large enough to have a significant effect on short rates. First, we expect that the extra $100bn in demand for bills, 2y tFRNs, Agencies, and government repo will push those yields sharply lower throughout the year -- even with the Fed expected to raise interest rates midyear. Estimating the magnitude of the downside pressure on these rates is difficult -- particularly given their already low levels. That said, we think it is safe to assume that the spread between (market) Treasury repo and the overnight RRP rate will narrow -- from 8bp currently -- to perhaps 4bp or less. The spread was below 4bp for most of last year. We expect 3m bills and shorter will trade 5bp or more below the overnight RRP rate. These effects are likely to become more pronounced in Q3 and Q4 as these money funds' bank holdings are replaced."
Also, he says, "All things equal, and given the similarity between investors and lenders in the fed funds and repo markets, we would expect that lower (market) Treasury repo rates would pull the effective funds rate down. We think the term unsecured rates will behave differently than the effective funds rate.... But, the scale of the effect on CP and other bank unsecured bank funding rates depends on the type of borrowing bank and whether other prime funds adopt the same "status change" strategy."
Barclays' Abate writes, "Industry-wide there is $1400bn in prime funds of which roughly $900bn is in institutional funds. On average roughly 60% of these balances are invested in bank CP and CDs. Thus the wholesale conversion of prime funds into government-only funds would shift between $540bn and $840bn worth of unsecured bank debt into government paper and repo. We suspect that this would be massively disruptive -- pushing government debt and repo rates sharply lower as Libor and rates on bank CP and CDs surge. Moreover, the rate implications of shift don't require all prime funds to disappear. Since the money fund industry is so highly concentrated even if only one or two money fund sponsors decides to follow suit, the swing in balances from bank credit to government paper could still be quite large."
Finally, he adds, "Our sense is that there could be many prime funds that convert to government-only funds given their clients demand for same day liquidity and stable NAVs. Indeed, converting to a government-only money fund seems to be the best strategy for money fund sponsors seeking to retain balances in the current low rate environment and with the very narrow spread between prime and government-only money fund yields. Of course, once interest rates start rising -- and the current 2-3bp spread between the 7d return on prime and government-only money funds widens -- investors may become more selective and willing to forgo some of their stable NAV preference for the higher yields in prime funds. And at that point, some of the cash that flowed into government-only funds will migrate back into prime funds, putting downward pressure on CP and CD rates."
Citi Research's Vikram Rai also examined the repercussions in his "Short Duration Strategy" commentary. "Given Fidelity's status as an industry leader, this announcement could influence other MMF managers to adopt similar strategies, especially since many more MMF managers are likely to have received similar feedback from their clients; i.e., they want access to money market mutual funds with a stable NAV that will not be subject to liquidity fees or redemption gates, which would restrict their use of these funds. The key question now on everyone's minds is if this will serve as the catalyst that will open the floodgates for large outflows from institutional prime funds. The combined AUM for all institutional prime funds is about $927 billion, and the numbers that have been bandied around by market participants with respect to the size of potential outflows range from $100 billion to $700 billion."
He continues, "We have maintained that wider credit spreads will serve as a counterbalancing force against outflows. Currently, the yield differential between institutional prime funds and institutional govt. funds is about 2-3bp. But, an increase in this spread could incentivize corporate treasurers and other investors to modify their guidelines such that they are able to invest in floating-NAV funds and take advantage of higher yields. Thus, the initial outflows from institutional prime funds will serve as part of the process that will build up to much wider credit spreads (which will in turn stanch outflows and maintain a lid on yields for credit products)."
Rai concludes, "The MMF industry is likely to undergo a slightly unsettled phase, if you will, as key players in the industry tweak their business models before they hit upon the optimum combination to navigate the post-SEC MMF world. In addition, we can expect some knee-jerk reactions on the part of smaller MMFs if they witness outflows. But, we do see a stable landscape ahead for the industry even though it may take more than a year for things to settle down."
