A $1 Trillion Paradigm Shift Changes Funding Markets Forever

  • BlackRock, Fidelity say money-fund reform is boon for Treasury
  • Floating NAV comes at expense of banks, corporate borrowers

It’s the most sweeping change for U.S. money market funds in over three decades and the biggest operators say it’ll have a permanent effect on the way investors allocate their capital.

After years of wrangling with regulators, the $2.7 trillion industry will give up its rock-solid, dollar-for-dollar guarantee for institutional funds that invest mainly in riskier, non-government debt.

The impending change has been a boon for the U.S. government and comes at the expense of banks and other corporate borrowers. Already, investors have shifted more than $1 trillion away from so-called prime funds that buy certificates of deposit and company IOUs and flooded into government-only funds, which invest in T-bills and other short-term U.S. debt and are exempt from the change. Assets in those funds, which never exceeded 40 percent before December, now account for 77 percent of all money-market assets, according to Investment Company Institute data going back to 2007.

The $1-per-share fixed price, which gave investors the perception these higher-yielding money-market funds were as safe as bank accounts, will give way to floating values on Oct. 14. The intent has been to make the money-market industry safer and more transparent in the wake of the financial crisis, when the collapse of the $62.5 billion Reserve Primary Fund -- which invested in debt issued by Lehman Brothers Holdings Inc. -- sparked a run on other prime funds and led to hundreds of millions in investor losses.

Yet to BlackRock Inc., Fidelity Investments and Vanguard Group Inc., the influx also represents a long-term shift that may help contain America’s funding costs just as bigger deficits loom and the Federal Reserve considers raising interest rates again. The ramifications are significant as well for banks and other corporate borrowers, which have seen financing costs jump as demand for the prime money-market funds that buy their debt has dried up.

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“These are permanent changes,” said Nancy Prior, the president of fixed income at Fidelity, the largest U.S. provider of money-market funds with $470 billion of such assets. “As the features of money funds changed, investors’ preferences led to these shifts in billions of dollars across the market. Assets in government funds will continue to surpass those in prime funds.”

The fixed net asset value has historically meant that money-market investors were always able to get every dollar of their principal back, regardless of the market’s fluctuations. And prime funds, which buy CDs and commercial paper, were an attractive alternative to bank accounts because they delivered slightly higher returns and were perceived to be just as safe.

But this week, the U.S. Securities and Exchange Commission will start requiring institutional prime and tax-exempt money-market funds to float their NAVs. That means that unlike government-only funds, investors can lose money if the market value of such funds fall below $1 per share. In addition, both institutional and retail classes of those funds will be allowed to impose liquidity fees and limit investor withdrawals in times of crisis.

The changes were designed to prevent a repeat of 2008, when the Reserve Primary Fund fell below its $1-a-share mandated value and subsequently collapsed under the weight of its Lehman-related write-offs. It spurred a panic among money-market investors and deepened the financial crisis.

Prime Exodus

The reforms have triggered an exodus from prime funds. Assets in that category have plunged by $974 billion in the past year to $473 billion. Almost all of it has flowed into government-only funds, which have doubled to $2.05 trillion over the same span.

“There is a lot of uncertainty around prime funds,” said Tom Callahan, head of global cash management at BlackRock, the second biggest money-market fund company with about $250 billion of such assets. “For some, it’s the floating NAVs. For some, it’s the gates and for some, it’s the fees. For some it’s all of the above.”

The shift in demand will be key as government spending on Social Security, Medicare and Medicaid widens the budget shortfall. The public debt burden may swell by almost $10 trillion in the coming decade, according to Congressional Budget Office forecasts, and the U.S. government has already taken advantage of the increase in bill demand to boost issuance.

“The Treasury is probably real happy with the results,” said David Glocke, the head of taxable money markets and Treasury bond trading at Vanguard, which manages about $195 billion in money-fund assets. “They can increase the issuance at the short-end of the curve and take advantage of it.”

That’s already playing out in the relative cost of borrowing. While all market rates have risen since the Fed raised rates in December, banks and corporate borrowers have borne the brunt of the money-market reforms. The gap between the three-month T-bill rate and the comparable London interbank offered rate -- a proxy for unsecured bank funding costs -- jumped to 0.69 percentage point in the past month, the most since 2009.

Corporate IOUs

Corporate IOUs have also been hit. The amount of commercial paper outstanding has declined for six consecutive months to a level not seen since the late 1990s. The market for IOUs issued by foreign financial firms, which are particularly dependent on money-market demand, is in the midst of the worst downturn since the credit crisis.

“This was a structural change,” said Gregory Fayvilevich, an analyst in the fund and asset management group at Fitch Ratings. “Prime money funds traditionally made up a very big portion of holders of CP. That is why you are seeing a very big impact.”

Deborah Cunningham, the chief investment officer for global money markets at Federated Investors, says that investors will slowly reallocate money back to prime funds as the yield advantage grows. Though she says, the gap needs to reach somewhere “north of 40 basis points” (or 0.4 percentage point) to offset the perceived risks.

The seven-day yield for institutional prime funds stood at 0.29 percent as of Oct. 6, versus 0.17 percent for government funds, according to Crane Data LLC.

The Treasury plans to sell $138 billion of bills on Tuesday.

“What we saw flow out was pretty quickly exiting, whereas what will come back will be spread over time, in drips and drabs,” Cunningham said.

Even if the appetite for prime funds eventually recovers, the additional risks like the floating NAV and the potential lock-ups suggest that government-only funds will continue to garner the lion’s share of any new inflows.

Demand for prime funds isn’t “ever going to make it back to what it was pre-reform,” said John Donohue, the chief investment officer for global liquidity at JPMorgan Asset Management, the third-largest money fund provider with $240 billion in assets. “In the new world, the govvie funds will be the large flagship in the money funds space.”

— With assistance by Christopher Condon

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