It's the most sweeping change for U.S. money market funds in over threedecades, and the biggest operators say it'll have a permanenteffect on the way investors allocate their capital.

After years of wrangling with regulators, the $2.7 trillionindustry will give up its rock-solid, dollar-for-dollarguarantee for institutional funds that invest mainly inriskier, non-government debt.

The impending change has been a boon for the U.S. government andcomes at the expense of banks and other corporate borrowers.Already, investors have shifted more than $1 trillion away fromso-called prime funds that buy certificates of deposit and companyIOUs and flooded into government-only funds, which invest inTreasury bills and other short-term U.S. debt and are exempt fromthe change. Assets in those funds, which never exceeded 40% beforeDecember, now account for 77% of all money-market assets, accordingto Investment Company Institute data going back to 2007.

The $1-per-share fixed price, which gave investors theperception these higher-yielding money-market funds were as safe asbank accounts, will give way to floating values on Oct.14. The intent has been to make the money-market industry safer andmore transparent in the wake of the financial crisis, when thecollapse of the $62.5 billion Reserve Primary Fund — which investedin debt issued by Lehman Brothers Holdings Inc. — sparked a run onother prime funds and led to hundreds of millions in investorlosses.

Yet to BlackRock Inc., Fidelity Investments and Vanguard GroupInc., the influx also represents a long-term shift that may helpcontain America's funding costs just as bigger deficits loomand the Federal Reserve considers raising interest rates again. Theramifications are significant as well for banks and other corporateborrowers, which have seen financing costs jump as demand for theprime money-market funds that buy their debt has dried up.

“These are permanent changes,” said Nancy Prior, the presidentof fixed income at Fidelity, the largest U.S. provider ofmoney-market funds with $470 billion of such assets. “As thefeatures of money funds changed, investors' preferences led tothese shifts in billions of dollars across the market. Assets ingovernment funds will continue to surpass those in primefunds.”

The fixed net-asset value historically has meant thatmoney-market investors were always able to get every dollar oftheir principal back, regardless of the market's fluctuations. Andprime funds, which buy CDs and commercial paper, were an attractivealternative to bank accounts because they delivered slightly higherreturns and were perceived to be just as safe.

But this week, the U.S. Securities and Exchange Commission willstart requiring institutional prime and tax-exempt money-marketfunds to float their NAVs. That means that unlike government-onlyfunds, investors can lose money if the market value of such fundsfalls below $1 per share. In addition, both institutional andretail classes of those funds will be allowed to impose liquidityfees and limit investor withdrawals in times of crisis.

The changes were designed to prevent a repeat of 2008, when theReserve Primary Fund fell below its $1-a-share mandated value andsubsequently collapsed under the weight of its Lehman-relatedwrite-offs. It spurred a panic among money-market investors anddeepened the financial crisis.

Prime Exodus

The reforms have triggered an exodus from prime funds. Assets inthat category have plunged by $974 billion in the past year to $473billion. Almost all of it has flowed into government-only funds,which have doubled to $2.05 trillion over the same span.

“There is a lot of uncertainty around prime funds,” said TomCallahan, the co-head of global cash management at BlackRock, thesecond biggest money-market fund company with about $250 billion ofsuch assets. “For some, it's the floating NAVs. For some, it's thegates and for some, it's the fees. For some it's all of theabove.”

The shift in demand will be key as government spending on SocialSecurity, Medicare and Medicaid widens the budget shortfall. Thepublic debt burden may swell by almost $10 trillion in the comingdecade, according to Congressional Budget Office forecasts, and theU.S. government has already taken advantage of the increase in billdemand to boost issuance.

“The Treasury is probably real happy with the results,” saidDavid Glocke, the head of taxable money markets and Treasury bondtrading at Vanguard, which manages about $195 billion in money-fundassets. “They can increase the issuance at the short end of thecurve and take advantage of it.”

That's already playing out in the relative cost of borrowing.While all market rates have risen since the Fed raised rates inDecember, banks and corporate borrowers have borne the brunt of themoney-market reforms. The gap between the three-month T-bill rateand the comparable London interbank offered rate — a proxy forunsecured bank funding costs — jumped to 0.69 percentage point inthe past month, the most since 2009.

Corporate IOUs

Corporate IOUs have also been hit. The amount of commercialpaper outstanding has declined for six consecutive months to alevel not seen since the late 1990s. The market for IOUs issued byforeign financial firms, which are particularly dependent onmoney-market demand, is in the midst of the worst downturn sincethe credit crisis.

“This was a structural change,” said Gregory Fayvilevich, ananalyst in the fund and asset management group at Fitch Ratings.“Prime money funds traditionally made up a very big portion ofholders of CP. That is why you are seeing a very big impact.”

Deborah Cunningham, the chief investment officer for globalmoney markets at Federated Investors, says that investors willslowly reallocate money back to prime funds as the yield advantagegrows. Though she says, the gap needs to reach somewhere “north of40 basis points” (or 0.4 percentage point) to offset the perceivedrisks.

The seven-day yield for institutional prime funds stood at0.29% as of Oct. 6, versus 0.17% for government funds, according toCrane Data LLC.

The Treasury plans to sell $138 billion of bills today.

“What we saw flow out was pretty quickly exiting, whereas whatwill come back will be spread over time, in drips and drabs,”Cunningham said.

Even if the appetite for prime funds eventually recovers, theadditional risks like the floating NAV and the potential lock-upssuggest that government-only funds will continue to garner thelion's share of any new inflows.

Demand for prime funds isn't “ever going to make it back to whatit was pre-reform,” said John Donohue, the chief investment officerfor global liquidity at JPMorgan Asset Management, thethird-largest money fund provider with $240 billion in assets. “Inthe new world, the govvie funds will be the large flagship in themoney funds space.”

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