The U.S. government's attempt to alleviate the short supply ofT-bills is about to get a little harder.

After years in the making, a post-crisis rule to prevent a run on the money-marketindustry will finally take effect this October. It will forcefunds that oversee about $600 billion to abandon a fixed $1-a-shareprice and float their net asset value (NAV). But because businessesand state governments treat the funds like bank accounts, theprospect of prices falling below a buck is causing a big shift into money-market funds that buy only governmentdebt.

To cope, the Treasury Department stepped up bill issuance andboosted supply by almost a quarter-trillion dollars after its shareof U.S. government debt fell to multi-decade lows last year. Thatstill might not be enough. Estimates suggest between now andmid-October, the influx may produce an extra $400 billion or morein demand for short-term government securities and put a squeeze ona sizable chunk of the $1.51 trillion bill market.

“Theremay be just enough bills out there to be handling this now,” saidGennadiy Goldberg, an interest-rate strategist at TD Securities.“But if there is another $400 billion inflow into government funds,that could put more pressure” on bill supply, he said.

Nobody is saying all that money will cause the market for bills,which mature in a year or less and make up 11 percent of U.S.Treasuries, to malfunction. After all, the government-only fundscan also buy repurchase agreements, debt issued by federal agenciesor put cash into the Federal Reserve's reserve repo program. Butthat's not to say there aren't real consequences.

Depressed rates in the $2.6 trillion money-market fund industrystand to deprive savers of income even as the Fed moves togradually raise interest rates. Some analysts say the Treasury mayeven be compelled to introduce two-month bills, which could hamperits goal of extending maturities to lock in long-term borrowingcosts while they're still near historic lows.

'Stampede' to Treasuries

For decades, the rock-solid $1-a-share NAV has been thecornerstone of money-market funds—the thing that made them as goodas cash in the eyes of investors. And prime funds, which invest inriskier assets, have been a favorite among state and corporatetreasurers because they delivered slightly higher returns thangovernment-only funds.

But on Oct. 14, institutional prime funds, which are big buyersof bank debt like commercial paper and certificates ofdeposits, will be required to float their NAVs. In recognition ofthe hard lessons learned in the dark days of Lehman BrothersHoldings Inc., they will also be allowed to impose liquidity feesand limit withdrawals in times of crisis. While the rules wereadopted to make money-market funds safer, they're spurring anexodus from prime funds and a stampede into government-only funds,which are exempt.

“When it comes to treasurers and their roles andresponsibilities, the last thing they want is uncertainty,'' saidBrandon Semilof, a managing director at StoneCastle CashManagement, which manages more than $10.6 billion and worksprimarily with the nation's community banks.

Kentucky has switched the cash that it's earmarked for debtpayments into government-only funds, according to Stephen Jones,deputy executive director of the commonwealth's office of financialmanagement.

If we're late on those payments, “we have a real seriousproblem, so we can't take the chance on a prime fund on that,” hesaid in an interview.

Since June of last year, assets in all funds that focus onbuying government funds have ballooned by more than a half-trilliondollars and now stand at about $1.5 trillion, according to CraneData LLC, which specializes in money-market research. That influxis likely to accelerate in coming months. Bank of AmericaCorp. predicts half the $300 billion to $500 billion leaving primefunds will flow into the safer money-market alternatives.

Some distortions have already begun to emerge. The premium onthree-month commercial paper has surged to a four-year high versussimilar-maturity bills, which yielded 0.24 percent today. The sameis true for the three-month London interbank offered rate, whichtouched the highest level since 2009.

“The inflows to government funds should mean relatively lowerTreasury bill yields and repo rates,” said William Marshall, aninterest-rate strategist at Credit Suisse Group AG.

Rock Bottom

Bill rates rose from rock-bottom levels in the lead-up to theFed's rate increase last December, but they've held steady since.Across all maturities, they average 0.28 percent, data compiled byBank of America show.

More bill issuance from the Treasury and the Fed's reverse repoprogram will help mitigate any supply-demand issues, according toMichael Pak, a fixed-income trader at TCW Group Inc., whichoversees $195 billion.

The Treasury will add about $188 billion in additional billsupply during the next two quarters, based on overall U.S.debt sales and how much cash on hand it plans to hold,according to Stone & McCarthy Research Associates.

“Finding the high-quality securities will not be a problem,” Paksaid. “The Treasury's stated desire is to issue more bills and runup a higher cash balance.” In addition, the Fed's reverse repos are“almost like a safety net.”

In recent months, the Treasury has said it would keep long-termdebt issuance stable as it increases bill supply. In February, italso discussed adding a two-month bill, partly to deal with therise in money-market demand.

That runs counter to the government's long-term goal of pushingout debt maturities to take advantage of a one-in-a-lifetimeopportunity with yields so low. The Treasury has lengthened theaverage maturity of U.S. government debt to a near-record 5.8years from 4.1 years in 2008. But it's decreased in two of thepast three quarters.

Whatever happens to bill supply, money-market providers are bracing for big redemptions from primefunds. For the biggest institutional prime funds tracked byCrane Data, the weighted average maturity of their holdings fell toa record 18 days last week.

“We expect some fairly large outflows,” said Peter Yi, directorof short-term fixed income at Northern Trust Corp., which manages$906 billion. “We don't want to find ourselves selling creditinstruments into a distressed market.”

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