Highland Associates on MMF Reforms
Institutional investment advisor Highland Associates published a white paper on "Money Market Reform," which says, "Significant rules changes in the $2.8 trillion money market industry have, and will continue to affect everything from fund manager behaviors to return expectations and yield spreads. Broader macroeconomic forces -- including Federal Reserve policy and government bond issuance -- will also impact risks and opportunities in the cash markets. To cope with these changes, investors must determine the role of cash in their portfolios, including its functions as both a source of liquidity and principal protection. There has already been a substantial shift in assets from institutional prime money market funds to government money market funds in anticipation of these rules changes. Higher costs associated with reform implementation are cited as the primary driver of the shift. Crane Data, which publishes Money Fund Intelligence, estimates that roughly $272 billion in prime money market assets had either 1) liquidated, 2) converted to government money funds, or 3) planned to convert to government funds before October 2016. This accounts for nearly 10% of total money market assets. Roughly $100 billion of this $272 billion in prime assets had not converted as of the end of February, although Crane Data expects nearly half of this amount to convert by the end of May." The Highland paper continues, "Money market fund investors should not expect meaningful increases in yield going forward for several reasons. The aforementioned conversion from prime to government funds is driving strong demand for government securities at a time when supply is quite constrained. Demand may even accelerate as the October deadline for reform compliance nears, with hundreds of billions of dollars potentially moving into government securities. On the supply side, more restrictive regulations are curtailing issuance across short-term debt markets.... Anecdotally, the supply of Treasury bills, agency discount notes, and dealer repo balances have declined by $600 billion, $500 billion, and $300 billion since 2009. Treasury bills currently account for just 11% of total debt outstanding, a record low. In addition, the pace of Fed rate hikes is likely to occur more gradually than originally anticipated.... Investors must begin to consider all of the options available for their cash investments. Both prime and government funds will remain widely available and suitable for many investors, regardless of recent rules changes." The piece concludes, "Investors should carefully consider the role of cash in their portfolios to be properly positioned amid these significant changes in short-term debt markets. Highland believes that cash has historically served two distinct functions for investors: 1) liquidity and 2) principal preservation.... Focusing strictly on liquidity and capital preservation, government money market funds represent an attractive option for investors looking to control risks at all costs. The tradeoff to lower risk is lower yield, and investors should not expect government fund yields to keep up with prime fund yields that can take more risk. Yield spreads between prime and government funds have widened in the last few months as conversions to government funds have depressed yields on those securities. While the yield advantage on prime funds is currently only 15 basis points, this spread could widen another 40-50 basis points by the October reform compliance deadline. Investors must decide if the incremental risk is worth the limited return advantage. Investors with significant cash holdings may consider dividing their positions. Investments in government money market funds represent the best allocation for cash that must remain immediately accessible. For less immediate cash needs, yield driven investments in enhanced cash or short-term debt portfolios should earn a higher yield, although the risk of small losses in principal must be noted."
