Money Market Reform Creates Arbitrage for Short-Term Investors

  • Bond managers can earn extra half percentage point interest
  • Eurodollar futures trim risk in commercial paper trade

Money market reform has a silver lining for some investors.

Bond managers can earn more than half a percentage point of extra interest annualized by buying securities that money market funds are shunning now and by using derivatives to trim the risk, said Dan Dektar, chief investment officer at Amundi Smith Breeden LLC in Durham, North Carolina.

“This is one example of the things you can do in the money markets to improve returns,” Dektar said. The higher returns have “arisen due to safety-minded reform and not due to a deterioration in the soundness of the financial system,” he said. Amundi Smith Breeden manages around $10 billion of assets.

Rules that came into effect in October have dimmed demand for certain kinds of debt -- in particular, short-term debt known as commercial paper, a near $1 trillion market of securities issued by companies including banks. The regulations are designed to make the funds safer after a major manager went under during the financial crisis.

Higher Yields

That lack of demand has driven yields higher on commercial paper maturing in six months, Dektar said. In recent weeks Amundi bought commercial paper issued by banks that yielded around 1.32 percent, for example, around the six-month Libor level and a more than seven-year high for the benchmark.

The Federal Reserve is raising rates -- it hiked in December for the second time in a year, and the median forecast for voting members implies that the central bank will lift rates three more times next year. That risk can be hedged with Eurodollar futures, Dektar said.

An investor buying three-month commercial paper now earns about 1 percent, based on Libor rates. If the six-month yield is 1.32 percent, that implies that in the second three months of the note’s life, investors will receive an annualized rate of around 1.64 percent. Hedging out the risk of the second three months using Eurodollar futures costs 1.07 percent, meaning an investor can earn an annualized 0.57 percentage point for the second three months while taking relatively little interest-rate risk.

“This is like buying Libor at 57 basis points over Libor,” Dektar said. “It illustrates how disjointed the market has become.” The scenario has occurred in previous years, though is usually associated with stress in the system, according to Dektar.

Credit Risk

There are risks to such a trade, as it means exposure to the underlying credit, according to Wells Fargo Securities LLC strategist Boris Rjavinski.

“You may be able to hedge the Libor component covering the life span of the commercial paper,” he said. “But what may happen is the credit spread of the entity issuing the paper widens, even if Libor doesn’t move. That creates a risk in the trade.”

In October, rules came into effect that require riskier money market funds to pass their paper losses on securities onto investors. Money market funds have historically allowed investors to buy and sell their shares at $1 apiece, which makes the funds seem safe and stable to customers. Under the new rule, if the funds are buying commercial paper and other non-government securities, they must record paper gains and losses daily on the securities they hold, and pass those gains or losses onto investors. That creates an incentive for investors in money market funds to gravitate to funds that buy only government debt.

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