By now most investors are familiar with the pending SEC money fund reforms, but what about the knock-on effects of these reforms? What will they mean for investors? Northern Trust tackled some of these questions in a white paper released last week called "SEC Money Market Reform: Investor Implications." Author Jennifer Sheroian, short duration fixed income portfolio manager, writes, "While firms have approximately two years to implement these reforms, late 2015 and 2016 will prove pivotal for transition and change. Here is what we believe investors should expect heading into and after implementation. In the next 12-24 months, money market fund investors are likely to see: More liquidity, shorter maturity; More reliance on Federal Reserve's Reverse Repo Facility, U.S. Treasuries; and U.S. agencies; Steeper yield curve for credit; and, Narrowing spread for overnight investments."
Under "More liquidity and shorter maturity," the piece says, "Portfolio managers likely will increase liquidity and shorten weighted average maturity to prepare for potential outflows from institutional prime and tax-exempt MMMFs as the SEC compliance deadline approaches. Institutional prime MMMFs could accomplish this by decreasing their exposure to corporate debt -- mostly financials -- and increasing their exposure to U.S. Treasuries, U.S. agencies and repurchase agreements backed with government collateral. U.S. Treasuries and U.S. agency debt are the most liquid securities; therefore, portfolio managers would opt to hold these types of securities during a period of potential outflows."
Regarding the "Steeper yield curve," Northern says, "U.S. Treasuries and U.S. agency debt are the most liquid assets in the money market sector, defined primarily by the SEC Rule 2a-7 that governs registered MMMFs. Therefore, we expect institutional prime MMMFs will begin to increase their holdings of U.S. Treasuries and U.S. agencies to prepare for investors who wish to transition to a constant net asset value (NAV) government MMMF exempt from the SEC's mandated structural changes. We believe this may steepen the yield curve and widen spreads for eligible 2a7 investments, outside of U.S. Treasuries and U.S. agencies. Steepening could occur if prime MMMFs start reinvesting proceeds of their bank certificate of deposit (CD)/commercial paper (CP) maturities into U.S. debt instead of reinvesting it with financial institutions. Currently, three-month CDs have a spread of around 17 basis points (bps) over three-month U.S. Treasury bills. On average, three-month bank CDs yield around 19 bps compared to a three-month U.S. Treasury bill set at 2 bps. However, heightened demand for U.S. Treasuries and U.S. agencies ultimately could push yields lower and dampen demand for typical term investment instruments. These typical-term instruments, traditionally relied on by prime funds, could see yields spike in order to attract investors."
On "Narrower spreads for overnight investments, they comment, "Overnight maturity time deposits relied upon by money market funds would attract even higher demand as institutional prime 2a-7 funds build their overnight cash positions to prepare for potential outflows. In the current environment for overnight investments, most time deposits pay a premium over agency discount notes, repurchase agreements and the Federal Reserve's reverse repo facility, except on quarter-end and year-end. Even now, however, it is not unusual for financial institutions to limit the amount of overnight cash they accept. We expect this dynamic will continue, especially as banks conform to new regulations by lowering their needs for short-term funding and money funds demand a greater supply of time deposits, since they will be holding more short-term cash. The spread also could narrow among all overnight investment options as more cash is positioned at the very front end of the yield curve, chasing fewer assets."
Northern explains, "Firms also likely will manage institutional prime money market funds more conservatively to help ensure the funds are well-positioned to avoid instituting a liquidity fee or redemption gate if weekly liquid assets fall below the 30% threshold. As a result, these funds are likely to increase their allocation to instruments categorized as daily and weekly liquid assets. Daily liquid assets are comprised of cash, U.S. Treasuries and any security that matures in one business day or is subject to a demand feature that can be exercised and payable within one business day. Of course, weekly liquid assets include daily liquid assets but also include U.S. agency discount notes issued at a discount with a maturity within 60 days and any security that matures in five business days or is subject to a demand feature that can be exercised and payable within five business days."
Regarding a "Growing reliance on repo," the paper states, "Institutional prime money market funds will also rely more heavily on repurchase agreements as fund managers prepare for the possibility of potential outflows. This poses an interesting scenario, since dealer balance sheets have been declining due to recent bank regulations that somewhat handicap dealers' repo balances by making it more costly for dealers to fund." Specifically, they cite Basel III and the Liquidity Coverage Ratio as two regulations that are affecting the supply of repo. "Since the LCR requires banks to hold high quality liquidity assets against a 30-day stressed period of expected net cash outflows, this ultimately leads banks to limit their funding maturing within 30 days."
A section entitled, "Overnight RRP a lifesaver for MMFs?" tells us, "The Federal Reserve's Overnight Reverse Repo Facility is an alternative to dealer repos for 165 new eligible counterparties that currently include money market funds in excess of $5 billion assets under management, government-sponsored enterprises, banks and primary dealers. Since operational exercises for the facility began on September 23, 2013, the facility has seen the most demand when bank funding is most scarce.... One of the facility's goals is to help put a floor on short term interest rates. However, if the current process is not improved, it is unlikely this facility will become full allotment or that the number of counterparties will be expanded much beyond the current approved counterparties; therefore, the goal of setting a rate floor would become impossible. It also appears that the FOMC is perhaps rethinking the full allotment and that the program will remain capped at a certain dollar amount, especially after the steps taken to modify the program in September and December. A term reverse repo option was introduced in December to help alleviate year-end pains, like the overnight facility it was capped at the maximum $300 billion. They also have introduced additional testing of the term reverse repo facility for February and March 2015."
Finally, Northern says that "Demand may outstrip supply." They say, "We think these new MMMF reform regulations may foster strong demand that likely will outstrip supplies of high-quality, short-term assets. This could help keep yields in the short end of the curve relatively low even after the Fed starts tightening monetary policy and rates begin rising."
