Preparing for funds that float.
Mutual fund giant Fidelity signaled a change in the money-market fund landscape with its January announcement that it plans to convert some of its prime money funds into government funds.
The conversion of the prime funds--those that invest in corporate securities--seems to anticipate a mass move by investors out of prime funds in response to new Securities and Exchange Commission (SEC) regulations. Those rules will require institutional prime funds to adopt a floating net asset value (NAV), instead of the stable, $1-a-share NAV investors are accustomed to, and will allow funds to use redemption fees and gates to discourage withdrawals in times of market stress.
The changes are expected to discourage many corporate treasurers from investing in prime funds. But proposals by the federal government that would alleviate some problems related to the rules changes, and the prospect of higher yields on prime funds, could help reconcile treasurers to using prime funds in their altered form, some observers say.
Lance Pan, director of research at Capitol Advisors Group, an independent investment adviser, described Fidelity as an "industry bellwether" and said other firms are likely to follow its lead.
To the extent that many fund companies do convert prime funds to government funds, the shift could affect the prices of short-term government and corporate debt.
According to a February report by Barclays economist Joseph Abate, prime funds hold $1.4 trillion in assets, and about 60% of those assets are invested in bank commercial paper and CDs. Widespread conversions of prime funds into government funds could mean that from $540 billion to $840 billion currently invested in banks' short-term securities would move to Treasury and agency securities, Abate estimated. That could be "massively disruptive--pushing government debt and repo rates sharply lower as Libor and rates on bank [commercial paper] and CDs surge," he wrote.
As the proposed SEC changes were debated in recent years, surveys of corporate finance executives showed that many planned to move their funds out of prime money funds rather than deal with the accounting and tax consequences of a variable NAV, as well as the impact of fees and gates on their ability to access their funds.
Brandon Semilof, a managing director at asset management firm StoneCastle Partners, said that while the use of a variable NAV would discourage some investors from using prime funds, it was the prospect of gates and liquidity fees "that pushed most investors over the edge.
"The idea of being in a money market fund is the flexibility it offers, and that's daily liquidity," he said.
There's no sign yet of institutional investors exiting prime funds, but Semilof said that's because the new regulations don't go into effect until October of next year.
"That's a lot of time for the treasury of XYZ Co. to move their funds," he said. "Whereas a firm like Fidelity, it will take them a calendar year to convert a prime fund into a government fund."
But Anthony Carfang, a partner at consultancy Treasury Strategies, said the changes that are coming in prime funds don't look as forbidding as they did initially because the federal government is proposing "substantial relief" related to some of the accounting and tax problems the new rules posed.
The Treasury Department is proposing that companies and other institutional investors can rely on a variable NAV fund's recordkeeping, rather than having to track the fund's gains and losses on a daily basis themselves, Carfang said. Treasury also proposed relief from the Internal Revenue Service's wash-sale rule, which in a variable NAV setting might have posed a problem for investors who buy and sell money funds frequently. And the SEC decided that funds can continue to use amortized cost accounting for any holdings that mature in 60 days or less, Carfang said.
"When a fund buys, say, $1 million and pays $992,000 for commercial paper that will mature in six months, they take that discount--$8,000--and record a certain amount of interest every day until it matures," he said. "Because they're amortizing it, that allows them to keep a constant net asset value."
Since securities maturing in 60 days or less make up a big part of most money funds, the ability to continue to use amortized cost accounting means that "the actual fluctuation in the variable NAV could be quite minuscule," Carfang said.
He downplayed the significance of liquidity fees and gates, arguing that those elements just put prime funds on a level playing field with other money market instruments, all of which have features that operate in a similar way.
For example, a treasurer holding individual securities who had to sell those securities into a distressed market would take a loss, and a company that redeemed bank CDs early would pay a penalty for early withdrawal, both similar to liquidity fees. Carfang compared gates to the situation investors in auction-rate securities faced when that market froze in 2008.
One part of the market that definitely will switch out of prime funds unless fund companies can develop an alternative product is sweep accounts, which automatically move funds out of a bank account into some sort of short-term investment, Carfang said.
"Sweep accounts do require precisely a dollar in and a dollar out," he said. "Even though the daily fluctuations [in variable NAV funds] will be minuscule, most banks and securities dealers that offer sweeps probably won't want to take the risk of any kind of fluctuation at all."
Pan agreed that sweep accounts won't use variable NAV funds. "Right now the consensus is that just about every institutional investor needs some kind of stable NAV product, at least for their sweep function," he said.
"It could be government fund, an insured deposit or [money market deposit account], or some kind of private fund--that needs to be solved.
"Once that puzzle is solved, it's a matter of what percentage of your portfolio you need to leave in that stable NAV product," Pan said.
In the current low-interest-rate environment, there's very little difference between the yields on prime and government funds. But Pan said that will change as the Fed raises rates and the yield curve steepens. He put the historical spread between government and prime funds at 50 basis points but said that spread is likely to be larger going forward "because the spread difference between corporate and government securities will be larger."
At some point, the yield advantage prime funds offer over government funds could get to a level that offsets the disadvantages of a floating NAV fund for corporate investors. Ed Baldry, CEO for Europe, the Middle East, and Asia at Institutional Cash Distributors, a money fund portal, said that while "a fair percentage" of corporate treasurers will probably switch from prime to government funds to keep a stable NAV, if the spread between government and prime funds gets to "30 basis points, a lot of the corporates we deal with are going to reconsider.
"What a lot of our customers are talking about is a laddered approach," Baldry added, in which they use government funds for operational funds and put "next-day money" in prime funds.
"Corporations and institutions are going to have to decide whether they're willing to accept these minuscule daily fluctuations [in a prime fund's NAV] to get the higher yield a prime fund offers," Carfang said. "Our sense is many corporates will answer that question yes."