Cabana on Prime MMFs "Catch 22""
Bank of America Merrill Lynch Rates Strategist Mark Cabana published a brief entitled, "Prime money funds: liquidity vs yield," which discusses how "Prime money funds have been shortening the tenor of their holdings to increase liquidity and meet potential outflows" and how this "challenges prime fund ability to generate yield sufficient to keep investors in the product after full money fund reform." Cabana explains, "Ahead of full implementation for money fund reform in October prime money funds have been shortening the tenor of their holdings in order to increase liquidity and meet potential outflows. This has likely provided some upward pressure on commercial paper and LIBOR-OIS spreads, including around the 6-month tenor which now rolls into the money fund reform window.... According to Crane Data, prime money fund holdings of financial CP (commercial paper) and CD (certificates of deposit) with final maturities of greater than 6 months have declined from around 15% at the end of September to 7% at the end of March. Across prime funds, maturities with over 180 days now comprise less than 5% of total assets and this has challenged their ability to generate return." A section, "Sacrificing yield for liquidity to meet potential outflows," explains, "Prime funds find themselves in a bit of a "catch-22" ahead of October. Prime fund managers need to take duration risk to generate yields that are sufficiently attractive for investors to remain in the product, but have received very little clarity from investors about how much cash will remain invested after the implementation date. Given this uncertainty and the potential for redemptions, prime fund managers have needed to shorten duration to stay liquid. This has caused prime funds to increase their amounts of daily and weekly liquidity while also shortening their weighted average maturities and weighted average lives.... Declining duration and increased liquidity makes it challenging for prime funds to generate sufficient yield such that investors feel compensated for the risk of a potential liquidity fee or redemption gate.... The current 7-day yield spread between prime and government funds is 16bps according to Crane, so some additional yield pickup could be required." Finally, he adds, "Given the uncertainty around investor behavior and subsequent need to stay liquid, there will likely be additional flows out of prime money funds ahead of full implementation date. When taken in the context of the $230 billion in prime fund outflows since the start of 2015 and the nearly $300 billion in announced prime to government conversions (with roughly $75 billion yet to fully convert), we now believe flows out of prime funds could total $600 to $800 billion.... We believe that risks skew towards the high end of this range but continue to acknowledge uncertainty around our estimate. We also continue to believe outflows will likely increase over the summer and into the fall. Shifts out of prime funds should result in a further increase in LIBOR-OIS spreads and a widening of shorter-dated swap spreads."
