An important corner of the US financial system has suffered a notable $1tn earthquake this year, rattling funding conditions for companies, banks and even US states. But some asset managers sense opportunities in the shifting landscape.
Money market funds have for decades been a vital lubricant of the global financial system, funnelling household savings and corporate cash piles into short-term loans to companies and banks around the world. Even many US municipalities tap MMFs for short-term funding.
However, US regulators introduced a series of industry reforms in the wake of the financial crisis, which finally come into effect on October 14. From then on, most MMFs will have to let their value float freely — rather than promising to always repay investors at par which, until the crisis, was the convention — and will be able to impose withdrawal fees and even suspend outflows at times of turmoil.
This has triggered an exodus by investors who largely use these vehicles as an ultra-safe cash substitute. The outflows have accelerated lately, with the total amount of money sloshing out of “prime” and municipal MMFs — that invest in the bonds of top-rated companies as well as the debt of municipalities — topping $1tn last week, according to the Investment Company Institute. Asset managers are now contemplating what the industry will look like in the future.
“The prime money market fund will not be what it once was. But this is an opportunity,” says Bob Browne, chief investment officer at Northern Trust, an asset manager. “There is a lot of money that has to land somewhere. It’s not often that you see hundreds of billions of dollars in play.”
Some of the money has simply trickled into bank accounts, but most has — for now — gone into MMFs dedicated to Treasuries, which are exempt from the new rules. Indeed, many prime funds have simply converted into ones dedicated to US government bonds, which have nearly doubled in size this year to about $2tn. In contrast, the prime MMF industry has shrunk from nearly $1.5tn at the start of the year to just $583bn.
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This has helped subdue the yields on short-term Treasury bills but led to sharply higher short-term funding costs for banks, companies and US municipalities. The steady climb in the three-month Libor, a global borrowing benchmark that affects trillions of dollars’ worth of debt, has been particularly notable against the backdrop of low interest rates and falling bond yields.
In fact, the rise in short-term corporate borrowing costs — the average annual yield on three-month commercial paper has more than quintupled to 85 basis points this year — has attracted a clutch of new investors, primarily bond funds and hedge funds, that have taken advantage of the juicier returns now on offer. That has helped moderate the rise recently, but may not be a long-term solution.
“Capitalising on the dislocations is a great thing, but it’s hard to envisage that these funds can replace the old prime money market funds,” says Jonas Kolk, chief investment officer for global liquidity products at Morgan Stanley Investment Management. “Pockets of money will move into different products, but it’s hard to say exactly where it will all end up.”
Among the potential winners are “ultra-short” bond funds. They offer much of the same security and liquidity as a prime fund, but with some more flexibility and therefore often slightly higher yields. There have only been four new launches of ultra-short bond funds in 2016, in line with previous years according to Morningstar data, but there are some hints of rising interest.
For example, MSIM’s ultra-short fund was launched at the end of April, and now has over $575m of assets. Pimco’s MINT short maturity bond ETF has seen total assets increase 22 per cent this year to $5bn, while Guggenheim’s short-duration ETF has nudged up from $623m to $913m over the same period.
Many asset managers reckon that once the dust settles, investors will take an even closer look. “New regulation has decimated a part of the money market fund industry,” says Jon Mondillo, a portfolio manager at Alpine Funds. “That said, it creates opportunity for something else. I think short-term bond funds are that opportunity.”
But the conundrum confronting the prime MMF industry is whether it will ever recover its old heft. The assumption has been that investors will tiptoe back once uncertainty caused by the regulatory changes has passed, but experts sound an increasingly sceptical note.
“It is a fundamental change,” points out Dave Fishman, head of liquidity solutions at Goldman Sachs Asset Management. “I can’t say whether it is a forever change. It is a change that I think is going to persist for the short to medium term. Longer term is tougher to project. Rates are the ultimate arbiter of these markets.”
Brian Reid, the ICI’s chief economist, also expects higher returns to eventually entice some investors back to prime MMFs, but points out that most prioritise safety, liquidity and returns in that order, and argues that the industry will remain a shadow of its former self for the foreseeable future. “Asset managers will have to rebuild this market, and it will take time.”