J.P. Morgan Securities published its "Short-Term Fixed Income 2018 Outlook" last week, and discussed "developments that will shape short-term fixed income" next year. Authors Alex Roever, Teresa Ho, and Ryan Lessing write, "Post MMF reform, the investor base is more diversified, the maturity profile of the CP/CD market is longer, and there has been more repo funding. In 2018, we don't anticipate these dynamics to change anytime soon." They explain, "The first year following money market reform proved an eventful one for short-term fixed income markets. While the 2016 US MMF reforms directly prompted important changes in market structure like the $1tn+ asset rotation from prime to government MMFs, other developments like the growth of the government repo markets over the past two years and the increased footprint of SMAs and low duration funds were also influenced by reform, one or two ripples removed from the center of the splash.” We excerpt from their update below.
J.P. Morgan's "U.S. Fixed Income" publication tells us, "[T]his past October marked the first anniversary of MMF reform. Since its implementation, the regulation profoundly transformed the money markets, changing the ways issuers look for funding and the balance of buying power among short duration investors. The fact was prime MMFs no longer held a dominant presence in the money markets. Issuers could no longer rely on them as a source of short-term funding. Even so, one year later, there continues to be plenty of liquidity in the money markets. Somewhat surprisingly, volumes and spreads have increased and narrowed, respectively, even as the markets have evolved. To that end, it's worth considering how the money markets have changed since last October."
It notes, "One of the biggest developments over the past year has been the increased participation from non-2a-7 investors. While prime MMFs historically dominated credit in the money markets, this year we have seen increased participation from securities lenders, short-term bond funds, and separately managed accounts (SMAs). In fact, their participation has more than filled the gap left behind by prime MMFs over the past year. Year over year, CP/CD outstandings have grown by nearly $200bn, even as the size of prime MMFs is less than a third of what it was before.... With the exception of ABCP which saw a slight decline in balances, outstandings of non-financial CP, financial CP and Yankee CDs all saw growth over the past year."
Roever explains, "To be sure, their involvement has helped to continue to support the CP/CD markets and allowed issuers to tap a broader set of investors for funding. At this point last year, we were unsure whether they would remain active participants given their longer duration mandates relative to MMFs. They became engaged in the very front-end of the money markets largely for opportunistic reasons, only becoming involved when credit spreads widened beyond historic norms. Interestingly, even as credit spreads tightened significantly this year, they remained engaged in the markets, squashing any concerns that capacity in the CP/CD market would decrease as cash migrated out of prime MMFs."
He points out, "In 2018, we suspect issuers will continue to benefit from the expanded investor base. Assets under management for many of these liquidity investors have grown over the past year, albeit slowly, and we don't anticipate this dynamic to change anytime soon. For prime MMFs, balances increased $70bn YTD, in what seemed like a rotation out of government MMFs as their balances fell $55bn. Investors appear to be gradually getting more comfortable with floating NAVs. And as the Fed continues to raise rates, the increased yield on prime MMFs versus government MMFs and/or bank deposits will likely attract a little more cash into prime MMFs."
The update tells us, "For securities lenders, cash reinvestment balances have also seen a rise this year, following years of steady decline. Securities lending activity has increased $80bn YTD as dealers have become more efficient in optimizing their balance sheets, thereby providing more cash collateral to reinvest.... Meanwhile, short-term bond funds and SMAs have also seen increased demand.... The noise around MMF reform in recent years as well as the rising interest rate environment prompted liquidity-focused investors to consider alternatives to MMFs, and many have deployed new cash to these products. It's not surprising then that data from Morningstar as well as our SMA survey show that assets in short-term bond funds and SMAs grew 12% and 16% respectively over the past year."
It continues, "With the expanded investor base, we've also seen a shift in the maturity profile of money market issuance. Recall the tug of war that used to exist between banks that want to issue longer-term and prime MMFs that want to stay short. Differences in regulations were driving issuers and investors in opposite directions from a maturity perspective. That said, this year we have seen a notable extension in issuer WAMs. In the bank space in particular, based on data from DTCC, we estimate WAMs of unsecured bank CP/CD in the money markets are about 50 days longer now than last summer."
The JP Morgan piece adds, "Away from credit, the amount of repo funding has also seen a significant increase this year. The shift in assets from prime MMFs to government MMFs changed the way issuers access money market funds for funding. Mirroring the shift in assets, banks began significantly borrowing from government MMFs on a secured basis. Year over year, dealer repo balances with MMFs grew about 30%, from $542bn as of last September to now slightly over $700bn.... From the perspective of government MMFs, the additional repo supply was welcomed. It came at a time when Treasury could not issue as many bills as it worked its way through the debt ceiling. With $2.0tn of AUM, government MMFs turned to repo as a source of supply. From the perspective of dealers, the increased demand for repo was also welcomed. Not only was it a cheaper source of funding, but it also allowed dealers to monetize their GC flows, by borrowing GC collateral in the tri-party market and lending it out in the GCF market. Dealers earn the spread in between."
It continues, "We think this type of trade is one of the reasons why we’ve seen such a large increase in repo balances with government MMFs among the French and Canadian banks. Indeed, a look at their US branch balance sheets shows similar growth in their reverse repo (asset) and repo (liabilities) balances.... It's also the case that we have seen government MMFs take on a more active role in centrally cleared repo, particularly in the form of sponsored repo programs. Though usage remains small (as of October month-end, only $12bn traded between FICC and government MMFs), we suspect this program will continue to grow as investors see this as an alternate source of supply to bills and discos."
Finally, they comment, "Ultimately, the implementation of MMF reform brought about significant changes to the money markets. We believe most of these changes have been positive: the investor base is more diversified, and the maturity profile of the CP/CD market is longer, both of which suggests less liquidity risk in the marketplace. The increased amount of repo funding has also been helpful against a backdrop of less bill supply, which in turn likely provided more liquidity to the Treasury markets. And based on what we know now, we don't anticipate these positive dynamics to change anytime soon."
