This month, Money Fund Intelligence interviews BlackRock's William Henderson, Managing Director & Lead Portfolio Manager on the Municipal Liquidity Portfolio Team, and Jack Erbeck, Managing Director & Municipal Credit Analyst. BlackRock manages $9.2 billion in Tax-Exempt money fund assets, including the $2.5 billion BIF Tax Exempt MF and the $1.4 billion BlackRock MuniFund. (BlackRock is also poised to almost double its Tax-Exempt MMF assets once it acquires BofA's cash business in April 2016.) Henderson has been running Tax-Exempt money funds for BlackRock since 1993, and Erbeck has been a credit analyst supporting Tax-Exempt funds since 1999. We discuss recent events in the Tax-Exempt or Municipal money markets below. (Note: This article originally appeared in the December issue of MFI on Dec. 7.)

MFI: How long has BlackRock been running Tax-Exempt cash? Henderson: Our flagship Tax Exempt money market fund, the BlackRock Muni Fund, began operations in 1980. We have a variety of Tax-Exempt funds -- the BlackRock Liquidity Funds, the BlackRock Institutional Funds, and the BlackRock retail funds. They are all managed here in Princeton, where we conduct tax-exempt fund portfolio management and credit research. It's all part of Blackrock's $110 billion municipal platform.... My number one priority is to keep the client and fiduciary responsibility front-and-center for the team.

MFI: What are the challenges in running these funds? Henderson: In the Tax-Exempt space, it's always been supply and demand, except for 2008 and 2009 when we had credit concerns that took precedence. This continues to be the biggest challenge in the industry. In fact, 2015 is the first time where total inventory of outstanding Variable Rate Demand Notes (VRDNs) fell below assets of Tax-Exempt money market funds. This puts constraints on our industry in terms of getting invested. This, along with collapsing TOBs (Tender Option Bonds), limited participation of new letters of credit, and fewer large issues of notes, are the key challenges. This year you have a lot of states not issuing one year paper -- Texas and California, for example. That took out additional supply that would have been creditworthy investments for our Tax-Exempt funds. So, it's an ongoing challenge of getting the funds invested in securities that we would deem credit worthy for the portfolios.

MFI: Are there regulatory reasons for constricting supply? Henderson: New regulations have impacted tender option bond issuance. It has changed the way banks are allowed to issue and support tender option bonds, and it doesn't make the creation of those securities as easy as it once was. So that's one small piece of the regulatory environment that has challenged what used to be [one] solution to the supply and demand issue. When there was a need for supply, banks issued tender option bonds. It was that simple. New regulations have placed restrictions on how TOBs are allowed to be issued and held by banks.

MFI: What are you buying now? Henderson: It's still approximately 75% VRDNs and 25% fixed rate paper, so notes, CP, and bonds. That mix really hasn't changed over the years -- it may get a little bit more skewed to notes after note season and then a little less so during tax season when you're building up liquidity. But we really aren't changing much in terms of the makeup of the portfolios. Muni funds are highly liquid and that's just by the nature of the way VRDNs are structured. There are certainly a greater number of smaller issuers than in the taxable space for sure. Here in the Tax-Exempt space there are a few big issuers -- California, Texas and New York -- and the rest is made up of all the other state, county, and local municipalities.

MFI: Tell us about your credit process. Erbeck: At a high level, it is dictated by the focus of the tax-exempt funds. We look at the small issuers for Bill's team, particularly Ohio, New Jersey, and places where we have state specific fund products. We evaluate municipal credits across the curve, looking at long term supply and we leverage the research team for our money market funds. The supply is down for cash flow notes, as well as for bond anticipation notes, so municipalities have been more conservative on their capital budgeting and reticent to borrow. Though lower borrowing and better liquidity is a better credit story for municipal governments.

Henderson: The same analysts at BlackRock that are looking at 1-year paper are also looking at 30-year paper. So if a serial bond comes, we're able to buy it all the way out the curve, from 1-year out to 30. We just place it in different funds depending on who needs it here on the desk -- it could be the bond funds, it could be the money market funds, it could be the separately managed accounts. [But] right now, we are challenged by a lack of supply. We've been at zero or one basis point for an unprecedented time period here for SIFMA, which is the 7-day index of VRDNs. When the bulk of your portfolio floats off of SIFMA, it's difficult to get a yield that is attractive.

MFI: Are there any municipalities you're worried about or avoiding? Henderson: We make sure every name meets the credit criteria and the team reviews it. Obviously, there are a lot of headline names that we would not own in the portfolio -- that's just not consistent with our 'quality, stability, liquidity, yield' mantra. In this environment when yields are so low it is definitely not prudent to reach for yield.

MFI: Tell us about weekly liquidity. Henderson: The VRDNs carry a guaranteed put at par, so 75% of the portfolio can be converted to cash in a week or less. That allows for a very stable NAV, and it allows for a very high level of liquidity. You can meet client redemptions, and certainly it meets all of the measures of the new money market reform rules in terms of the amount of liquidity a fund must carry. The rule for Munis is 30% in weekly liquidity, but we don't have a daily test like the taxable funds. If you're carrying 75% to 80% in weekly liquidity, you're well above the 30% rule. So it's highly unlikely that you would ever have an issue where you're not carrying the required amount of liquidity. Gates and fees seem to be an item that people are concerned about, and certainly they can be imposed if a fund's 7-day liquidity drops below 30%. But when your portfolio is carrying 75% in weekly VRDNs on average, it's unlikely that you ever drop below 30%. Most clients understand this.

MFI: Have you decided which funds will be Institutional and Retail? Henderson: Yes, we just made an announcement.... We're going to have AAA-rated institutional offerings with Floating NAVs, and ... retail offerings at a constant NAV. Many of these changes aren't effective until next September however. We will continue to have state-specific funds where we believe there's a large retail interest due to high state income taxes. The platform will be efficient, and it's going to have all the offerings for the current make-up of our clients. We think it'll offer the right balance and meet the needs of our diverse client base.

MFI: Do shadow NAVs in the Tax Exempt sector move? Henderson: They actually move less [than taxable funds']. Look, 75% of the fund is priced at par, highly liquid, very high credit quality, so the likelihood of your shadow NAV moving is actually diminished compared to a laddered portfolio from zero up to 397 days. We've been publishing our shadow NAVs for some time and will continue to do so. It wasn't something that we did [just for] money market fund reform. We also have always done stress testing on all the portfolios for many years -- long before it was required.

MFI: Are Retail investors more stable? Henderson: First off, retail Tax-Exempt investors tend to move [too], just more slowly, because you're talking about thousands of accounts with smaller balances. The other thing is they tend to really be tax averse. They do not want to pay taxes. Even if yields are 1 bp in munis vs. a prime fund yielding 7 or 8 bps, they would still rather not pay any taxes. So you have those two things working in favor for stability in balances of retail Tax-Exempt money market funds -- the slow movement in general and then the aversion to paying taxes.

MFI: What factors have driven assets down in Tax Exempts? Is it just low rates? Henderson: That's part of it. But I think a greater force is a large base of the Tax Exempt money fund industry was retail investors, and that's who has fueled the stock and bond rallies over the last 7 years. The money had to come from somewhere, so investors moved out of funds into the market, out the curve and into equity and longer term bond funds.

MFI: What is your outlook for 2016? Henderson: I really do think 2016 is going to be an exciting year. We have money fund reform; the Fed is going to (hopefully) be raising rates; and, we're going to see large cash movements by clients -- that just has to happen. I'm not just talking about in the Tax Exempt space, but all throughout the money fund industry. We're going to see big movements of client cash. That's going to make for an interesting and challenging year.

BlackRock has always been committed to the Tax-Exempt money fund industry. In these times, it's even more important that we do the right job for our clients, and scale is important for getting that job done. We have the people in place and the size to make it all work. It has been critical for us to have a research team that partners with portfolio management and has been able to weather multiple interest rates environments and credit cycles to make sure we get the job done well.

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