There's been a lot of discussion about the future of prime funds since the SEC approved money market reforms last July, and rightfully so. But prime funds shouldn't be the only concern of MMF investors. Government funds, which came away from reforms largely unscathed, face their own set of challenges in a post-reform world, especially with a potential flood of new assets. Columbia Management's John McColley, portfolio manager, Liquidity Strategies, and Alice Flynn, senior product manager, discuss these issues in a new commentary, "Challenges Facing Government Money Market Funds." One of the biggest challenges will be lower yields, they say, so, "Investors seeking a higher yielding product may look to combining a government money market fund with one or more floating NAV retail funds." (Note: We also interview Columbia Management Ultra Short Manager Leonard Aplet, who has some comments on money fund reforms and alternatives, in the pending February issue of our new Bond Fund Intelligence.)
They write, "Six months have already passed since the SEC approved sweeping money market reforms to Rule 2a-7. However, most firms have yet to make a final decision on what money market products to include in their investment lineup come October 2016. Unlike the changes instituted in 2010 where fund managers had time to allow portfolios to shorten weighted average maturities naturally, these new changes will be much more disruptive to both investors and issuers in the short term markets. The cost to implement these new regulations (800+ pages of reforms) may prove to be prohibitive for smaller funds, with some firms already waiving the white flag."
Columbia continues, "For those still working through the systems/process changes and website modifications, a conundrum exists. Firms want to convert to the products that will be most desirable to their shareholders, but shareholders don't know what they want yet and are waiting to see what will be available. With time on the side of the investor, those firms that want to continue to be in the money market business are considering all options to retain and gather assets."
One option is government money market funds. "On the surface, this option appears to be the easiest solution for mutual fund families to implement and the structure of the fund will remain the closest to what investors are familiar with. However, government money market funds have been newly defined as investing 99.5% of their assets in cash, government securities or repurchase agreements that are fully collateralized. Shareholders will continue to use a stable $1 NAV and won't need to worry about redemption fees or liquidity gates. Fund families that change their institutional funds to government funds will also be able to retain the existing shareholder base as both natural persons and institutional investors can remain in the fund together.... Unfortunately, it is not possible or logical for all institutional or retail money market funds to convert to government money market funds, given so many variables and challenges that exist."
Will there be enough supply? They write, "[T}he September 30 available supply of short government paper totaled about $3.8 trillion, with roughly $1.5 trillion in T-Bills, $1.25 trillion in Treasury notes and bonds within one year of maturity, and an additional $1.1 trillion in qualifying agency securities. Should budget deficits decline, Treasury issuance will most certainly decline as well. Additionally, ICI reported that "as of June 2014, taxable money market funds held just $377 billion – or 13 percent – of short-term debt issued by the Treasury." The remaining supply of these securities is already owned by central banks, state and municipal governments, commercial banks and existing separate cash accounts. Even as the Fed begins to raise rates, the added demand from government money market funds to a potentially shrinking investable universe will cause spreads to widen and government securities to yield less than other money market securities."
They continue, "Within the Government Agency category, Federal Home Loan Bank (FHLB) has been a big issuer of debt but there is uncertainty whether Fannie Mae (FNMA) and Freddie Mac (FHLMC), both big agency issuers of agency discount notes, will continue to exist. There is also a question as to the long term access to the Fed's ON RRP (Overnight Reverse Repo Program). Usage typically spikes during quarter ends and the new money market reforms are expected to add to the short term market's reliance on this program as the scarcity of investable short-term Treasuries generally drives the importance of the RRP. If the Fed were to end the program, a reliable supply of government securities would be significantly impacted. Market participants have also speculated that an aggregate cap could be imposed on the facility, thereby restricting the supply of government securities when there could be increased demand."
A big challenge for government MMFs will be yield. They explain, "A government money market fund's inability to invest in spread products -- CP, ABCP, CD, VRDNs and legacy repo -- will limit the yield and total return potential. Government securities are already limited in their return potential given the additional yield that these other security types generally offer (in exchange for higher risk). Also, increased demand for Treasury and Agency securities will drive their prices higher and reduce the yield potential of the government securities even more."
Also, the competitive landscape will likely be more crowded. Columbia writes, "According to Peter Crane, president of Crane Data, a research firm that tracks money market funds, "the general consensus is that the big players in the money market industry are going to be prepared to offer all three types of money market funds, as well as develop other products where they see potential asset growth." Additional products under consideration for those investors looking for more yield and to avoid fees and gates include short-term bond and ultra short-term bond funds, private funds, expanding separate accounts business, and Federated is considering a 60-days and under maturity product, which keeps it under the SEC's money market reform radar."
What does the future hold? They conclude, "There will always be a long-term need for short-term assets, whatever one's investment style. Investors with no risk tolerance or who are required by regulatory guidelines or investment constraints mandating a stable $1 NAV will likely be the ones who gravitate towards government money market funds. Such funds may provide peace of mind and liquidity, but will be challenged to offer a competitive yield. On the other hand, investors seeking a higher yielding product may look to diversify their investments between multiple funds. Combining a stable $1 NAV government money market fund with one or more floating NAV retail funds may help investors increase the likelihood that the cash they may need will be available when they want it, should one or more funds be impacted by fees and gates. Whatever the flows may be in the category, it will be up to individual investors to determine their needs for cash investments and to select the investment products that best fit those needs."
