Last week we reported on the SEC's response to Frequently Asked Questions from money managers and others in the space about money market reforms. (See our story from April 23 News, "SEC Posts 2014 Money Market Fund Reform Frequently Asked Questions.) One of the 53 FAQs dealt with 60-day and under maximum maturity funds, which have been proposed by at least two major fund complexes so far, Federated and BlackRock, although the latter proposed 7 day and under maximum maturity funds. Others have said they are considering this option. The idea of these short duration funds is to limit the ability for these floating NAV institutional funds to float. JP Morgan Securities strategist Alex Roever singled out this particularly question in his commentary this week, discussing the SEC's response to the question and the broader implications of these funds. We also excerpt from SEC FAQ updates from Wells Fargo's Garret Sloan and from Ropes & Gray.
Writes Roever, "While most of the questions represent minor technical and legal topics, there were a couple questions that we think have broader implications for the short-term fixed income market, particularly as it relates to 60-day prime MMFs. In particular, the SEC clarified two aspects with respect to the establishment of 60-day MMFs. First, a MMF that is subject to a floating NAV may not advertise that it will seek to maintain a stable NAV by limiting its portfolio securities to a maturity of less than 60 days and valuing those securities using amortized cost. The SEC staff believes that such a statement would be confusing or misleading to investors, particularly during periods when the security’s amortized value differs from the security's mark-to-market value. This could happen during credit events or sudden market moving events. Under such a scenario, the MMF's NAV will fluctuate and not remain stable."
He continues, "While NAVs do fluctuate in value, over the past few years they have not deviated much from the $1.0000 stable NAV. Even during those circumstances, the lowest shadow NAV value carried among the prime funds was 0.9976. Still, the SEC advises that a floating NAV fund must advertise that the fund’s share price will fluctuate, which we suspect will deter at least some existing and potential institutional shareholders from participating. Second, a 60-day MMF that intends to use amortized cost to value its securities may not use "maturity shortening" provisions of Rule 2a-7 to determine the maturity date of those securities. Currently, Rule 2a-7 allows MMFs to shorten the maturities of variable and floating rate securities and repurchase agreements to their reset date or demand date for purposes of calculating their weighted average maturities. For example, MMFs are able to deem 1-year floaters whose benchmark resets every 90 days or 1-year floaters that are putable within 60 days or 3m repos that are putable within 7 days as having a maturity of 90 days, 60 days and 7 days respectively. However, for purposes of determining inclusion eligibility for 60-day MMFs, the funds would have to use the securities' legal final maturity."
He adds, "At various times, we have expressed our concern about the difficulty in establishing 60-day prime MMFs given the challenge in finding suitable supply to meet its specific type of demand. The inability to use current maturity shortening provisions raises further challenges. We estimate the elimination of this provision removes on average about $266bn of eligible supply based on money market floating rate note and putable note issuance over the past five years. Alternatively, funds may buy other short-term credit products such as CP or bank time deposits, but the stock of those assets don't fare much better. Indeed, as of April 17 the Fed reports that only about 56% or $568bn of CP outstanding mature in less than 42 days, consistent with the theme of banks trying to push out their short-term borrowings for liquidity purposes. With respect to bank time deposits, while most of these deposits are done on an overnight basis, banks are currently looking to shed their exposure given the deposits' regulatory burden."
Further, "Conceivably, given the supply constraint it's possible that returns on 60-day MMFs could yield very close to government MMFs, particularly considering there are a host of other short-term investors (e.g., 397-day max prime institutional MMFs, retail prime MMFs, corporations, hedge funds, etc.) competing for the same credit supply that is eligible for 60-day MMFs in order to meet their liquidity requirements. The lack of sufficient, suitable credit products could encourage them to buy more eligible rates products such as bills, repo, and discos. Faced with the choice to shift money into 60-day MMFs or government MMFs with no yield differential between the two, institutional shareholders could be inclined to choose the latter given the absence of a floating NAV and more importantly liquidity fees and gates. If this scenario is realized, we suspect this will incrementally increase the demand for short-term government securities. Fortunately, the SEC also clarified in the FAQs that the Fed's overnight repurchase agreements (ON RRP) are considered a government security and is not subject to issuer diversification limits. However, bank certificate of deposits, which are insured up to the $250,000 FDIC insurance limit, are not considered a government security."
Wells Fargo strategist Garret Sloan also had some thoughts on these funds. He writes in his April 23 commentary, "Following questions on form N-MFP, form N-CR and website disclosures, the first question we found to be meaningful was the clarity that investors will likely garner from the response to the question of whether 60-day funds will be able to be marketed as seeking to maintain a stable NAV by purchasing securities with a final maturity of 60 days or less, and valuing them at amortized cost? The SEC said that funds could not do this. In its response, the SEC noted that "a floating NAV money market fund (which would include 60-day institutional prime and municipal funds) may not state in its advertising, sales literature, or prospectus that it will seek to maintain a stable NAV by limiting its portfolio securities to only those securities with a remaining maturity of 60 days or less and valuing those securities using amortized cost, as such a statement would be misleading to investors." The SEC noted that if a security exhibited credit deterioration, amortized cost may not reflect fair market value even fore securities with maturities less than 60 days."
Sloan adds, "In response to a second question on amortized cost, the SEC clarified the differences between amortized cost usage in floating-NAV funds and stable-NAV funds by stating that amortized cost may be used in floating-NAV funds on an individual basis, but stable-NAV funds "may value their entire portfolio using the amortized cost method." This should help investors understand more fully that 60-day money funds will remain floating-NAV funds for operational purposes, and the perceived advantages associated with these structures may be somewhat spurious."
Finally, a brief entitled, "SEC Staff Responds to Frequently Asked Questions on 2014 Money Market Reform Release, Including Valuation Guidance," from Ropes & Gray, says, "On April 22, 2015, the Securities and Exchange Commission ("SEC") staff released guidance titled "2014 Money Market Fund Reform Frequently Asked Questions," that discusses various interpretive issues arising from the SEC's 2014 Money Market Fund Reform release (the "2014 Reform Release"). On April 23, 2015, the SEC staff released additional guidance, titled "Valuation Guidance Frequently Asked Questions," that discusses the valuation guidance applicable to all mutual funds that was included within the 2014 Reform Release. Both the April 22 release and the April 23 release (together, the "Guidance") were in a question-and-answer format and represent the views of the SEC's Division of Investment Management's staff (the "IM Staff"). This Alert discusses the highlights of the Guidance.
On "Valuation Guidance," Ropes writes, "In the Guidance, the IM Staff sought to clarify the scope of the responsibilities of a mutual fund's board of directors ("Board") when determining whether an evaluated price provided by a pricing service, or some other price, constitutes a fair value for a fund's portfolio security. In the 2014 Reform Release, the SEC made these three points: A Board has a non-delegable responsibility to determine whether an evaluated price provided by a pricing service, or some other price, constitutes a fair value for a fund's portfolio security. It is incumbent upon a Board to satisfy itself that all appropriate factors relevant to the fair value of securities have been considered, and that the Board must continuously review the appropriateness of the method used in fair valuing each security owned by the fund. Although a fund's Board cannot delegate their statutory duty to determine the fair value of fund portfolio securities, a Board may appoint others, such as the fund's investment adviser or a valuation committee, to assist them in determining fair value, and to make the actual calculations pursuant to the fair valuation methodologies previously approved by the Board."
The brief continues, "Arguably, these three points in the 2014 Reform Release suggested that a Board must be more intimately involved in the fair value process, perhaps even in real-time determinations of the appropriate methodology to fair value individual securities, than many practitioners had previously thought to be the case. In the Guidance, the IM Staff reiterated these three points. However, in the Guidance, at the outset of its response, the IM Staff stated: The staff believes that the guidance provided in the [2014 Reform Release] was not intended to change the general nature of the board's responsibility to oversee the process of determining whether an evaluated price provided by a pricing service, or some other price, constitutes a fair value for a fund's portfolio security or limit a board's ability to appropriately appoint others to assist in its duties. Therefore, it would appear that the IM Staff believes the 2014 Reform Release's valuation guidance does not expand a Board's responsibilities with respect to the fair value process. Instead, the Guidance indicates that a Board may wish to consider various factors in its oversight of evaluated prices that are supplied by third-party pricing services."
Finally, Ropes & Gray writes on "Additional Guidance?," "The Guidance stated that the IM Staff expects to update the Guidance from time to time to include responses to additional questions. Most notably, in early 2015, the Investment Company Institute (the "ICI") and the Securities Industry and Financial Markets Association submitted to the SEC a draft Q&A regarding the 2014 Reform Release. However, only two of the answers in the Guidance were expressly identified as corresponding to questions submitted by the ICI. Therefore, it should not be surprising if the IM Staff issues additional guidance in the near future, as the compliance dates for additional provisions of Rule 2a-7 approach."
