This month, MFI interviews Justin Schwartz, Head of Municipal Money Markets at the Vanguard Group. Vanguard is the 2nd largest manager of tax-exempt MMFs (and MMFs overall) with over $29.4 billion ($285.2B overall). Schwartz manages the $17.4 billion Vanguard Municipal Money Market Fund, the largest fund in the tax-exempt space. We discuss supply, credit, liquidity, and several other topics below. (Note: This interview is reprinted from the December issue of our flagship Money Fund Intelligence newsletter; contact us at inquiry@cranedata.com to request the full issue. Subscriptions to MFI are $500 a year or $1,000 including the MFI XLS spreadsheet "complement.")

MFI: Give us a little background. Schwartz: Vanguard began running tax exempt money market funds in 1980 with the launch of the Vanguard Tax Exempt MMF. At the time we launched, interest rates were in the double digits so it was a much different environment than today. We followed up with the launch of our state funds; most of which [were added] in the late '80s, with our final product being launched in 1997. So we've been managing tax exempt money funds for coming up on four decades.

In terms of my background, I joined the fixed income group of Vanguard in 2005 as a trader with our long-term bond funds. Subsequently, I joined the short-term municipal team in 2008, [which was] a challenging time to start a career in the money market space. But the lessons learned during the financial crisis are invaluable with regards to shaping my perspective on the proper ways to manage risk and liquidity in money market portfolios. I was promoted to fund manager in 2010 and most recently became head of the municipal short desk in 2016 following Pam Tynan's retirement. Along the way I've managed several of our state specific money funds. I currently manage our Vanguard Municipal Money Market and also Vanguard Short Term Tax Exempt Fund. My team consists of three portfolio managers and six traders. In addition to the money funds, we manage all the cash investments for our muni bond funds.

MFI: What's your biggest priority? Schwartz: The biggest priority, currently and always, is managing the product and ensuring the safety and liquidity of all of our money funds. Beyond that, exploring and investing in technology is a key initiative. We're continually looking to improve our current investment tools or add new tools to ensure we are providing best in class risk management, performance and efficiency for the funds.

The fund lineup is pretty set.... We liquidated the Ohio money fund product earlier this year. That leaves us with our flagship national product in the Vanguard Municipal MMF, and our four state funds for clients in California, New York, New Jersey and Pennsylvania.... We've always been very retail focused.... We do manage one institutional municipal money fund, but that product is only available internally to our municipal funds. I don't foresee us looking to publicly offer an institutional municipal fund at this point.

MFI: What's your biggest challenge? Schwartz: I think one of the biggest challenges ... is really adjusting to the dynamics of a new buyer base in the short term municipal market. Fifty percent of assets left the municipal money fund industry in a pretty short timeframe last year. However, most of this money didn't actually leave the front end; it just changed investment vehicles.... Our experience is that SMA or corporate cash managers often behave very differently than money fund managers do for varying reasons, including not being subject to the same set of regulations. So really learning and adjusting to the way these new buyers operate ... has been something we've been highly focused on

MFI: What are you buying? Schwartz: In terms of securities, we're very well diversified.... New issue supply has certainly been a challenge in the muni money market space post financial crisis, but there's plenty of product to buy.... Not much has changed in terms of what types of products we're buying. The dominant product in the municipal money market space continues to be the variable rate demand note. Our portfolios consist of 70-80% between daily variable rates and weekly variable rates; that includes TOB positions. Outside of that, on the margins we've been investing in slightly higher percentages of commercial paper.

One thing that we have been avoiding and mainly just from a valuation standpoint is fixed rates securities. Until recently, we really didn't think that they offered attractive break-evens given our projected path for Fed rate hikes.... With tax reform on the horizon and ... supply that's been pulled forward into the market, this dynamic has changed. Rates have backed up to a point where we are comfortable adding more fixed-rate paper and extended the funds WAMs.

We're always well in excess of the 30% weekly liquidity threshold, and this holds true across the board in the muni money market industry. The excess liquidity is due to the nature of the securities available for purchase in our market. It would take a large, wholesale shift away from VRDNs by the issuer and underwriting communities to really see liquidity numbers come down much.

MFI: Who are the biggest issuers? Schwartz: The national portfolio is very well diversified, geographically.... There are certain states -- California, Texas, New York -- that are heavy issuers in the municipal market.... Obviously there's a handful of states and cities that have some credit challenges in the market.... `Given our mandate in the money funds to focus on high quality credits that represent minimal credit risk for the portfolio, these are credits that we've been out of for quite some time. At Vanguard, we have what I believe to be a best in class credit team that helps us steer clear of these issuers, well before they become an a potential problem.

MFI: What about regulatory changes? Schwartz: Bank regulations have had a huge impact on these products over the years. [There's] declining supply in the VRDN space.... We can certainly attribute quite a bit of the drop off in supply to Basel III and the liquidity coverage ratio.... It makes issuing a letter of credit or a standby bond purchase agreement much less attractive for a bank.... This results in increased costs for municipal issuers.... Another substitute for VRDNs has been floating rate notes, which are products that generally are being bought by short-term bond funds.... Finally with historically low long-term fixed rates, you've seen a lot of issuers opt to term out their debt and lock in attractive long term financing rates.

MFI: Any customer concerns of late? Schwartz: I think the best feedback mechanism is cash flows. So I'd say, from that angle, we're certainly seeing investors pick their heads up and notice the higher yields that the funds are offering. We've seen solid growth in our funds this year, about $1 billion dollars in new inflows.... Looking forward, I would expect money funds to continue to become even more of a compelling option. When you think about the backdrop of a dramatically flattening yield curve, combined with the potential of four additional Fed hikes through 2018, we are entering the environment where money funds thrive. Looking back over time, money funds tend to see some of their best cash flows in periods when the yield curve is flattening or is very flat. Importantly, money funds are getting to a point where the rates we're offering are increasingly competitive relative to banking products ... even inclusive of high yield saving accounts. So, given all these things, I think we'd expect to see significant growth in these funds over the next couple years.

MFI: What about fees and waivers? Schwartz: The fees on our products are consistent with where they've been over the long term.... There were certain points in time where we did have to limit our expenses in order to maintain a positive yield for the investors. But we've returned to our full expense charge at this point.... We continue to offer very competitive expenses, relative to the industry.

MFI: Any thoughts on last year's reforms? Schwartz: Stepping back and looking at reform as a whole, it was an enormous effort internally and within the industry to make all of the necessary changes to become compliant with the new regulations. We saw a very rapid change in the investor landscape in the short-term municipal space, but ultimately despite a brief dislocation the market quickly found an equilibrium. The market has adapted to the new landscape and I think that we're left with a set of money fund products that will be able to continue to reliably serve our clients cash management needs for many decades to come.

MFI: Talk about the short-term muni fund. Schwartz: We have a full suite of funds across the maturity spectrum here. We've offered the Short-Term Tax-Exempt Fund since 1977. So it's ... not a new product for us.... The fund invests in bonds with maturities out to five years and in normal environments we maintain a duration of just over a one-year. It's generally a very high credit quality fund [but] we do have the ability to invest down the credit quality spectrum. These levers provide us opportunities to add some additional return relative to 2a-7 funds.

MFI: Tell us about your outlook. Schwartz: I do expect the Fed to hike rates 25 basis points this month and likely 3 more times in 2018. This should lead to a significantly higher 7-day SIFMA index as it adjust to the new effective Fed funds rate. What we've seen over the last year or so, is that yields in the municipal market do take a few weeks to effectively adjust to any rate hike. In this regard we do tend to lag the taxable market a bit. But the market always works itself out. If municipal rates are too low relative to taxable, investors will move their cash to the higher yielding option until the relative rates normalize.

As we look forward to the rest of this year and into next year, we expect [the funds to be] more attractive to our shareholders as the Fed continues to raise rates. It's rewarding as a fund manager to be able to offer a more attractive product in terms of yield. [But] as we found out from many years of offering very little yield, our shareholders [also] value very much the safety of principle and liquidity of the product offering.

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