The new regulations imposed on money market funds last fall triggered a huge migration of assets out of institutional prime funds. And three months after the changes took effect, institutional investors still seem to be wary of heading back into prime funds.
More than $1 trillion in assets exited institutional prime funds after the Securities and Exchange Commission said in 2014 that as of mid-October 2016, the funds had to float their net asset value (NAV) and establish redemption fees and gates. By the start of November, just $122.1 billion remained in institutional prime funds, down from $779.2 billion at the start of 2016, according to statistics from the Investment Company Institute. With the exception of a brief move higher around year-end, the total assets in institutional prime funds haven’t increased much; last week’s ICI data showed $129.6 billion in prime funds as of Jan. 11.
Most of the money that left prime funds headed into government funds, which are not required to float their NAVs or impose fees and gates. Institutional government funds, which held $868.6 billion in assets at the start of 2016, ended the year with $1.616 trillion.
The huge shift in assets was accomplished smoothly, which analysts credit to prime funds’ having maintained high levels of liquidity in order to accommodate investors’ redemptions, as well as to government funds’ ability to turn to the Federal Reserve’s reverse repo program if they had a hard time finding enough government securities.
“The industry did a really effective job of anticipating the outflows and making sure they had sufficient liquidity,” said Roger Merritt, a managing director at Fitch Ratings.
In the months since the implementation deadline, institutional prime funds have reversed the defensive positions, including shorter durations, that they took in the fall.
Funds’ liquidity ratios are key under the new SEC rules, which mandate that if a fund’s ratio slips below 30%, it is subject to fees or gates. Greg Fayvilevich, a senior director at Fitch Ratings, noted that heading into the October implementation of the new rules, some prime funds were maintaining weekly liquidity levels as high as 100%.
“Since then, that has gone down,” he said. “We’re still seeing levels of liquidity that are higher than historical norms pre-reform, but they’re certainly down.
“Now some are managing around 40% weekly liquidity,” he said, noting that that level provides some cushion above the 30% level investors will be watching for.
The other big change, in addition to the possibility of redemption fees and gates, was prime institutional funds’ adoption of floating net asset values, instead of the constant NAV of $1 they offered prior to the SEC’s reforms. But prime funds’ net asset values have been “remarkably stable” since NAVs began floating last fall, said Mark Cabana, head of U.S. short rates strategy at Bank of America Merrill Lynch.
“Just looking at some data from Crane [Data], it really seems like the average [NAV] level across prime institutional funds has stayed above $1 per share and really has not fluctuated all that much since they started floating,” Cabana said.
Those steady NAVs seem as though they should be reassuring to investors. And many analysts had predicted that while institutional investors were likely to exit prime funds ahead of the implementation of the new rules, they would start moving assets back into prime funds once the yield spread over government funds got to an attractive level. That spread has widened, but so far, investors aren’t heading back to prime funds.
Cabana cited iMoneyNet data showing that institutional prime funds are yielding about 87 basis points, which is 34 basis points more than institutional government funds. “That differential has widened as rates have moved higher and as the yields that have been offered on commercial paper and CDs have increased given the smaller overall investor base that participates in prime institutional funds,” he said.
He noted that a survey conducted by Bank of America Merrill Lynch last year about what investors expected to do in the two years after the rule changes showed respondents thought a yield pickup of 30 to 40 basis points would be attractive enough to lure them back into prime funds.
Cabana expects the yield spread to continue to widen over the first half of the year, and predicted that some investors will “think about moving back into prime funds or at least moving back into other alternatives that could enhance their yields, such as short-duration funds or enhanced cash funds.”
He said, though, that he doesn’t expect “a really dramatic shift” from government funds to other investments. “But it wouldn’t surprise me if over time we saw 10% or 20% of what has been invested in government funds utilized to try to enhance yield in one form or another,” Cabana said.
Fitch Ratings’ Merritt also expects that as the spread between government and prime funds continues to widen, some institutional investors will move back into prime funds or other alternatives. But he noted that to do so, investors may need to rework their investment guidelines, a process that can take time.
“It is going to be a slow process of moving from government [funds] to something else,” Fitch’s Fayvilevich said, citing the smaller size of institutional prime funds as a factor. “Investors generally would have limits in terms of how big the investor wants to be as part of the fund,” he said. “So it may take an iterative process until some prime funds are back to a bigger size.”
Lance Pan, director of investment research and strategy at Capital Advisors Group, noted one technical factor that could affect the spread between government and prime funds over the next couple of months: The U.S. debt ceiling is due to expire in March. If Congress delays renewing the debt ceiling, the Treasury may have to limit issuance of Treasury bills, creating a shortfall in supply, a factor that would depress rates on bills and boost the spread.
“That may get some people back into prime funds,” Pan said. “But it only works with the accounts that say, ‘We are comfortable going back into prime.’”
He argued that it’s too soon to expect corporate treasurers to be assessing a return to prime funds, and he predicted they won’t start thinking about that until “at the earliest March.”
Pan added, “If you think about the calendar effect of what corporate treasurers do, I don’t think the first 60 days [of the year] anyone is focusing on cash investments. They’re just trying to get their financials done, and then they have their first board meeting.”
Of course, if an institutional investor’s main concern is yield, there are short-term investments that offer higher returns than prime funds.
For example, ultrashort bond funds and private funds currently have yields “quite a bit above” those on institutional prime funds, Fayvilevich said.
At last November’s annual conference of the Association for Financial Professionals, a survey of attendees at a session on managing liquidity in the wake of the SEC’s reforms found 31% were considering separately managed accounts, 19% FDIC-insured accounts, 15% money funds with floating NAVs, 14% ultrashort bond funds, and 12% direct investments, according to StoneCastle Cash Management.
Cabana cited short-duration bond funds and enhanced cash funds as “two of the most compelling” alternatives to prime funds. “They offer a little duration risk, the ability to move a little further out the curve with the expectation that there will be a bit more volatility and price fluctuation but also greater reward,” he said.
Enhanced cash funds typically have duration ranges of six months to a year, while ultrashort bond funds range from six months to two years, Cabana said.
“These are not expected to fluctuate much, but the further out the curve you go, the more volatility you could see,” he added.
Pan said he wasn’t arguing for corporate investors to move back into prime funds. He said they can easily realize higher yields by investing in securities that are a little further out on the curve.
Investors should figure out how much of their short-term cash they might need near-term and put that portion in government money market funds, Pan suggested. Money that’s not needed short-term can be invested in a laddered bond portfolio in a separately managed account.
“Three-month Libor is over 1% now,” Pan said. “If you can take your liquidity risk out to 90 days or longer, you have your 1% right there.”
Corporate investors need to remember, though, that alternative short-term investments like ultrashort bond funds aren’t regulated as tightly as money market funds, and there’s not as much information available about them.
“The key consideration is to understand what you’re investing in,” said Merritt. “There’s not the same level of standardization in what someone calls an ultrashort bond fund in terms of what they invest in and how far out the yield curve they go.”