Half-Trillion-Dollar Exodus Magnifies Treasury Bill Shortage
One of the biggest winners in the push to make money-market funds safer for investors is turning out to be none other than the U.S. government.
Rules adopted by regulators last month will require money funds that invest in riskier assets to abandon their traditional $1 share-price floor and disclose daily changes in value. For companies that use the funds like bank accounts, the prospect of prices falling below $1 may prompt them to shift their cash into the shortest-term Treasuries, creating as much as $500 billion of demand in two years, according to Bank of America Corp.
Boeing Co., the world’s largest maker of planes, and the state of Maryland are already looking to make the switch to avoid the possibility of any potential losses. With the $1.39 trillion U.S. bill market accounting for the smallest share of Treasuries in six decades, the extra demand may help the world’s largest debtor nation contain its own funding costs as the Federal Reserve moves to raise interest rates.
“Whether investors move into government institutional money-market funds or just buy securities themselves, there will be a large demand” for short-dated debt, Jim Lee, head of U.S. derivatives strategy at Royal Bank of Scotland Group Plc’s capital markets unit in Stamford, Connecticut, said in a telephone interview on July 28. “That will lower yields.”
He predicts investors may shift as much as $350 billion to money-market funds that invest only in government debt.
During the past five years, America has enjoyed some of the lowest financing costs in its history as the Fed held its benchmark rate close to zero and bought trillions of dollars in bonds to restore demand after the credit crisis.
Based on prevailing Treasury bill rates, it costs the U.S. just 0.015 percent to borrow for three months as of 11:55 a.m. today in New York. In the five decades prior to 2008, the average was more than 5 percent.
Now, with traders pricing in a 58 percent chance the Fed will raise its overnight rate by July, speculation is building that borrowing costs are bound to increase. That’s made finding buyers for the nation’s debt securities even more important.
The sweeping rule changes in the money-market fund industry may help provide that demand. Since 1983, money-market funds have been permitted to keep share prices at $1, meaning a dollar invested can always be redeemed for a dollar.
Institutional prime money funds, which invest in short-term IOUs issued by companies known as commercial paper, are among the funds that will now have to report daily prices which may fluctuate based on their underlying holdings, according to rules adopted July 23 by the Securities and Exchange Commission.
The SEC the will also give the funds the ability to impose fees on redemptions and lock up investors’ money for as long as 10 days when a fund faces an inability to meet redemptions.
The changes are intended to prevent a repeat of 2008, when the collapse of the 37-year-old, $62.5 billion Reserve Primary Fund triggered a run on other money funds and deepened the worst financial crisis since the Great Depression.
Still, investors using prime funds to manage their idle cash may find floating prices an unnecessary risk when differences in fund rates are so minimal, said Brian Smedley, an interest-rate strategist at Bank of America in New York.
He estimates about half the $964 billion held in institutional prime funds will flow into those that only invest in government debt and yield about 0.013 percentage point less, before the new rules become fully effective in 2016.
“We’re not really getting paid for the risks associated” and the rules will make these funds even less attractive, Joseph D’Angelo, who oversees $70 billion as head of money-market fixed-income at Prudential Investment Management, said in a July 30 telephone interview from Newark, New Jersey.
Peter Crane, president of money-market researcher Crane Data LLC, anticipates fund values will remain stable because the underlying assets mature so quickly and are easily replaced. The shortest-term commercial paper comes due in two days.
Any exodus will be limited to about 10 percent of prime fund assets because the yield advantage over government-only funds will increase as the Fed starts raising rates, he said.
Credit Suisse Group AG also has a more conservative estimate and foresees $100 billion flowing out of prime funds, versus Bank of America’s half-trillion dollar projection.
“Very little will change,” Crane, who has been covering the industry for two decades, said in a telephone interview on July 28. “I expect it will prove that net asset values don’t actually prove to really float much.”
The prospect of prime money-market funds falling below $1 a share, known as “breaking the buck,” has already prompted some companies to weigh a shift to those that buy U.S. debt.
Boeing (BA), which usually keeps about $1.4 billion to $2 billion of its cash in prime funds, says it needs daily liquidity to pay suppliers and meet payroll and can’t afford any losses that would result from withdrawing money at less than the $1 a share the company put in.
On $1 billion of cash, a drop to 99.99 cents a share from $1 a share, the smallest increment allowed by the rule change, would result in a $100,000 decline excluding accrued interest.
“We’re definitely worried about breaking the buck,” Verett Mims, assistant treasurer at Chicago-based Boeing, said in a telephone interview on July 30. “That’s our biggest problem, the notion of principal preservation.”
The state of Maryland may also refrain from investing in prime money-market funds as a result of the floating-price rule, according to its treasurer, Nancy Kopp.
The changes “make these money market funds less usable, if not usable at all as investment vehicles,” she said in a July 22 conference call organized by the Chamber of Conference.
As more companies opt for the safety of government debt, the supply of Treasury bills stands to decrease further. With the Obama administration projecting the deficit will narrow to a six-year low of $583 billion, the Treasury Department has pared its issuance of the short-term debt.
U.S. government securities due in four weeks to one year account for just 11.5 percent of the $12.1 trillion market for Treasuries, the smallest proportion in data compiled by Barclays Plc going back to 1952. As recently as 2008, bills accounted for more than third of the total.
This lack of supply, coupled with the money-market fund shift, mean short-term rates will remain low, Deborah Cunningham, the head of money-market funds at Pittsburgh-based Federated Investors Inc., which oversees $245 billion in short-term securities, said in a July 31 telephone interview.
“The government wins out on this.”