US money markets watch for post-reform moves

A sweeping regulatory overhaul of the US money market that has prompted investors to pull around $1 trillion out of prime funds over the last year finally came into force in October. As the dust settles and investors and borrowers adjust to the new rules, market participants are trying to figure out how much of that cash might be lured back.

Prime US institutional funds, which buy short-term debt such as commercial paper, lost $790.8 billion of assets in the 12 months from November 2015 as investors baulked at regulatory changes that mean prime funds must adopt floating net-asset values instead of fixing their share price at $1. In addition, funds can now potentially lock up investors’ cash or impose liquidity fees in times of stress. Retail prime funds, which maintain a fixed share price but can still halt redemptions, lost $259.3 billion over the same period, according to data from the Investment Company Institute.

Mark Heppenstall,   Penn Mutual Asset Management

Much of those outflows ended up in government money market funds, which are exempt from the reforms. That move pushed the yield spread between prime institutional and government funds to 13 basis points at the end of October from 4bp a year ago, according to Crane Data. Market watchers predict that if spread widening persists, some investors might start reallocating their cash.

“The conventional thinking is once you get into a spread of 30bp to 40bp, that’s going to be attractive enough for investors to live with the floating NAV and the gates and fees element,” says Justin Rose, head of liquidity services at Western Asset Management.

Fitch Ratings says as outflows from prime funds slow and portfolio managers adopt less conservative strategies, such as extending maturities and reducing their liquidity cushions, spreads should continue to widen.

Chunkier spreads might not be enough to entice some investors back. Moody’s warns that given prime funds now have substantially smaller asset bases, corporate treasurers might be reluctant to park cash in funds with fewer shareholders.

But Rose says that while he expects at least half of those outflows have left prime funds for good, inflows could pick up in December if the US Federal Reserve raises interest rates and interbank borrowing costs move higher, boosting prime fund yields. 

The three-month dollar Libor was 0.88% at the end of October, up from around 0.3% a year ago, as reform-spurred outflows caused a number of US prime funds to shut and demand for short-term debt to wane. Just 91 prime funds remained at the end of September, down from 206 a year earlier, according to ICI data. That has reduced funding options for banks and companies and made it more expensive for them to borrow.

“This in isolation isn’t a major problem, but given all the other challenges facing banks it’s just one thing they really don’t need at a time when earnings are already challenged,” says Mark Heppenstall, chief investment officer at Penn Mutual Asset Management. 

Because of the impact on Libor, the reforms have had broader unintended implications for companies and banks that have accessed capital markets by issuing floating-rate debt.

“Borrowers’ funding costs have gone up without any change in their underlying fundamentals or credit ratings,” says James Meyers, director of fixed income product strategy at Invesco PowerShares.

The recent shift away from prime funds is also part of a longer-term trend that emerged in the wake of the financial crisis, where investors, spooked by money market turmoil, moved around $3.5 trillion out of money funds and into bank deposits, says Greg Hertrich, head of US bank depository strategy at Nomura. That transition has helped mitigate some of the drop in prime money market funding.

“We stand today with bank deposits sitting on bank balance sheets, anxiously awaiting the allocation into levered unrated credit, and as that occurs over time, that’s when you’ll start to see some changes in the dynamics of how that funding moves and whether that will look more like money market funds or traditional bank deposits,” says Hertrich.

If that cash is more rate sensitive than traditional bank deposits, banks could see some of that funding disappear as interest rates rise, he says. Even so, banks can still tap other sources of finance linked to US money market funds. “Federal Home Loan Bank borrowing has become a preferred option for bank borrowing, supplanting much of the market that had existed for commercial paper and certificates of deposit,” says Sean Collins, senior director for industry and financial analysis at ICI. 

“Federal Home Loan Banks are funding these loans by issuing floating-rate notes that can be bought by government money market funds.” How the reforms will affect short-term bank funding in the long run largely depends on the way investors use prime funds in the future – and that remains uncertain.

“Naturally, the market’s in a bit of a holding pattern right now,” says Collins. “People who are still in prime funds are deciding if it’s the best money management tool for them, while people who are in government funds are watching and evaluating the prime fund situation. Somewhere down the line it’s possible investors in either group may make different decisions as the full impact of the reforms becomes clearer.”