BlackRock Inc. and Western Asset Management Co. are offering anew twist on traditional money-market funds as regulators are setto impose sweeping changes on the $2.58 trillion industry.

BlackRock, the world's biggest money manager, and Legg MasonInc.'s Western Asset unit have started bond funds designed to workmuch like money funds, with a key difference. The new “ultra-short”funds have share prices that fluctuate along with the value oftheir holdings, rather than a fixed net asset value, or NAV, adistinguishing feature of money funds. They also have shortermaturities than similar ultra-short bond funds that ran intotrouble when credit markets froze in 2008.

The firms are preparing for what could be a seismic reallocationof assets by institutional investors and corporate treasurers ifregulators overhaul money funds for a second time in three years ina bid to make them safer after the 2008 collapse of the ReservePrimary Fund. The U.S. Securities and Exchange Commission plans toorder a floating NAV on institutional prime money-market funds, orthose that invest in corporate debt, overriding opposition from theindustry.

“We would expect to see more corporations use more vehicles thanare used today once we get to a floating NAV for prime money-marketfunds,” said Richard Hoerner, head of New York-based BlackRock'sglobal cash-management business. “The fund is designed forshort-term investors seeking to outperform money-market funds, withpotential returns that exceed those of prime money-market fundsunder normal market conditions.”

Mary Athridge, a spokeswoman for Baltimore-based Legg Mason,declined to comment on the Western Asset Ultra Short ObligationsFund, which the firm filed to register on May 8. BlackRock openedthe BlackRock Ultra-Short Obligations Fund in November, and it hasabout $25 million of assets.

The new funds are different from existing U.S. ultra-short bondfunds, which had $280.1 billion of assets at the end of last year,according to iMoneyNet, a Westborough, Massachusetts-based providerof money-market research and analysis. The funds, run by companiesranging from Pittsburgh-based Federated Investors Inc. toBoston-based Fidelity Investment, generally hold investment-gradedebt that matures in one to two years, according to a review ofregulatory filings.

The BlackRock and Western Asset funds have shorter maturitiesand can only invest in high-quality debt. Some short-term bondfunds that were touted as higher-yielding alternatives to moneyfunds faced severe losses in 2008 as they held debt tied tomortgages. State Street Corp.'s SSgA Yield Plus Fund fell 19percent in the first five months of 2008 before being liquidated.Charles Schwab Corp.'s YieldPlus fund fell to $1.8 billion inassets in 2008 from a peak of $13.5 billion in 2007, after itinvested more than 25 percent of fund assets in private issuermortgage-backed securities.

The BlackRock and Western Asset ultra-short bond funds have bothpledged to limit the average maturity of their portfolios to nomore than 90 days. That was the legal threshold for money-marketfunds until 2010, when the SEC lowered the ceiling to 60 days aspart of an earlier effort designed to reduce systemic risk. As withmoney funds, the BlackRock and Western products will primarily holddebt securities that mature in 397 days or less.

'Reshaping' Industry

Money-market funds are allowed to use an accounting method thatproduces a stable net asset value of $1 a share under Rule 2a-7 ofthe Investment Company Act of 1940. Investment earnings, ratherthan lifting the share price, are distributed in cash or newshares. This feature has made money-market funds a favorite amongindividuals, institutional investors, and corporations who want aplace to park their cash that will provide a higher return thanthose typically paid on bank deposits.

Federal regulators have been searching for ways to prevent areplay of September 2008, when the $62.5 billion Reserve PrimaryFund “broke the buck,” or fell below the $1 NAV. The collapsetriggered a wider run on money funds that contributed to a freezein the global credit markets. In 2010, the SEC tightened rules oncredit quality, shortened the maximum average maturity for fundsand introduced minimum liquidity levels. Mary Schapiro, then theSEC's chairman, called that a first step toward making money fundsmore stable and pushed a plan to make funds abandon their $1 shareprice or build capital reserves.

The industry, led by providers including Fidelity Investmentsand Federated Investors, fought back against proposals and soughtto limit the scope of changes. The SEC is now planning a narrowerproposal that requires the use of floating net asset values byinstitutional money-market funds that invest in corporate debt, aperson familiar with the matter said last week. Such a change wouldapply to funds managing $950 billion, or about 37 percent of U.S.money-fund assets, according to iMoneyNet.

The regulatory changes could lead to a “reshaping” of themoney-market industry, including changes to the “overall liquidityproduct landscape,” Moody's Investors Service said in a May 13report. One possible consequence would be growth in alternativecash products, including short-duration bond funds, developed bylarge money-market fund managers to offset the “expected loss” ofassets in prime funds hit by the new rule, the report said.

A lot of the innovation “has been held in abeyance waiting forthe SEC,” Geoff Bobroff, a mutual-fund consultant in EastGreenwich, Rhode Island, said in an interview. “People are startingto gear up” now that the SEC appears ready to act, Bobroffsaid.

Credit Quality

The BlackRock and Western Asset funds expect to invest at least25 percent of their assets in securities issued by companies in thefinancial services sector, such as banks and brokerages.

In terms of credit quality, BlackRock and Western will onlyinvest in fixed-income securities that have either the top orsecond-best short-term debt rating from credit-raters such asMoody's or Standard & Poor's. While the BlackRock fund can haveany amount of assets in the second-highest category, the WesternAsset fund must invest at least 95 percent of its assets in debtwith the top-tiered rating, the prior standard for money-marketfunds until the SEC raised it by two percentage points to 97percent in 2010.

“It sounds like a turbo-charged money-market fund,” said StevenShachat, a senior portfolio manager at Alpine Woods CapitalInvestors LLC in Purchase, New York. “It appears as if we might beheading in the direction of a floating NAV anyway, so they are justheading this off at the pass.”

BlackRock's Hoerner said the new ultra-short fund is “clearly”not a money-market fund, though at first glance it may “looksimilar” to one. In addition to the floating net asset value,Hoerner cited several other differences, such as the 2010 revisionsto Rule 2a-7 require money-market funds to keep 30 percent of theirassets in securities that mature within seven days. Neither theWestern Asset nor the BlackRock ultra- short fund have such aprovision.

The stable $1 value is one of the main appeals of money funds asinvestors seek the preservation of their capital amid record-lowinterest rates. Corporate money-market clients would be reluctantto give up the benefits of a stable net asset value for a slightlyhigher yield, said Shachat at Alpine Woods. “A lot of the majorcorporations are just so risk-averse,” Shachat said. “That is whyyou see Treasury funds with hundreds of billions of dollarsbasically earning zero.”

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