A $400 Billion Influx Squeezes U.S. Bond Market’s Safest Asset

  • Money-market funds must abandon $1-a-share NAV in October
  • Treasury may introduce two-month bills to cope with demand

The U.S. government’s attempt to alleviate the short supply of T-bills is about to get a little harder.

After years in the making, a post-crisis rule to prevent a run on the money-market industry will finally take effect this October. It will force funds that oversee about $600 billion to abandon a fixed $1-a-share price and float their net asset value. But because businesses and state governments treat the funds like bank accounts, the prospect of prices falling below a buck is causing a big shift into money-market funds that buy only government debt.

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

“There may be just enough bills out there to be handling this now,” said Gennadiy 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 funds can also buy repurchases agreements, debt issued by federal agencies or put cash into the Federal Reserve’s reserve repo program. But that’s not to say there aren’t real consequences.

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Depressed rates in the $2.6 trillion money-market fund industry stand to deprive savers of income even as the Fed moves to gradually raise interest rates. Some analysts say the Treasury may even be compelled to introduce two-month bills, which could hamper its goal of extending maturities to lock in long-term borrowing costs while they’re still near historic lows.

For decades, the rock-solid $1-a-share NAV has been the cornerstone of money-market funds -- the thing that made them as good as cash in the eyes of investors. And prime funds, which invest in riskier assets, have been a favorite among state and corporate treasurers because they delivered slightly higher returns than government-only funds.

Hard Lessons

But on Oct. 14, institutional prime funds, which are big buyers of bank debt like commercial paper and certificates of deposits, will be required to float their NAVs. In recognition of the hard lessons learned in the dark days of Lehman Brothers Holdings Inc., they will also be allowed to impose liquidity fees and limit withdrawals in times of crisis. While the rules were adopted to make money-market funds safer, they’re spurring an exodus from prime funds and a stampede into government-only funds, which are exempt.

“When it comes to Treasurers and their roles and responsibilities, the last thing they want is uncertainty,’’ said Brandon Semilof, a managing director at StoneCastle Cash Management, which manages more than $10.6 billion and works primarily with the nation’s community banks.

Kentucky has switched the cash that it’s earmarked for debt payments into government-only funds, according to Stephen Jones, deputy executive director of the commonwealth’s office of financial management.

If we’re late on those payments, “we have a real serious problem, so we can’t take the chance on a prime fund on that,” he said in an interview.

Since June of last year, assets in all funds that focus on buying government debt have ballooned by more than a half-trillion dollars and now stand at about $1.5 trillion, according to Crane Data LLC, which specializes in money-market research. That influx is likely to accelerate in coming months. Bank of America Corp. predicts half the $300 billion to $500 billion leaving prime funds will flow into the safer money-market alternatives.

3-Month Commercial Paper Yield Versus Comparable U.S. Bill Rate
3-Month Commercial Paper Yield Versus Comparable U.S. Bill Rate

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

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

Rock Bottom

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

More bill issuance from the Treasury and the Fed’s reverse repo program will help mitigate any supply-demand issues, according to Michael Pak, a fixed-income trader at TCW Group Inc., which oversees $195 billion.

The Treasury will add about $188 billion in additional bill supply 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,” Pak said. “The Treasury’s stated desire is to issue more bills and run up 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-term debt issuance stable as it increases bill supply. In February, it also discussed adding a two-month bill, partly to deal with the rise in money-market demand.

That runs counter to the government’s long-term goal of pushing out debt maturities to take advantage of a one-in-a-lifetime opportunity with yields so low. The Treasury has lengthened the average maturity of U.S. government debt to a near-record 5.8 years from 4.1 years in 2008. But it’s decreased in two of the past three quarters.

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

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

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