Post-Rule Change, Prime Funds in the Balance
October 14 has come and gone and there are a couple money market fund trends that may bode well for prime money market funds. One is that spreads between institutional prime and government MMFs have widened since the October 14 implementation of new SEC rules. The second is that prime fund portfolios’ weighted average maturities (WAM) have lengthened somewhat. These shifts may eventually bring back some lost luster to prime funds for corporate treasurers, but so far inflows have yet to materialize, and views split sharply about whether they ever will.
Prime institutional funds saw $872 billion flow out of them as of October 28 since the start of the year, bringing down the total invested in those funds to $383 billion as of October 27, according Treasury Strategies and Crane Data. Meanwhile, the volume of Treasury-bond MMFs increased over the same time period by $102 billion, to $603 billion. The biggest jump in volume, however, was with MMFs investing in government securities, which increased by $787 billion, to $1.463 trillion by October 28.
The outflow from prime funds has slowed to a trickle, with a mere $6 billion more bleeding out since mid-October. Anthony Carfang, managing director at Treasury Strategies, a Novantas company, said he does not anticipate anymore material outflow, and money will flow back when investors see “all clear” signals, such as longer weighted average maturities (WAM), asset inflows, and minuscule net asset value (NAV) fluctuation. He added that the money leaving prime funds went mostly to MMFs investing in government securities, including treasury and agency securities.
“We think that’s important to note because government funds rarely represent the maximum investor utility for corporate treasurers,” he said. “That tells us the money is using government funds as a temporary holding place, with the exception of money coming from sweep accounts, which require a constant net asset value—about a third of the new money in government MMFs.”
Corporate cash has several short-term alternatives, including bank deposits, structured deposits, certificates of deposit (CDs), commercial paper (CP), and repurchase agreements (repos). Mr. Carfang said corporates’ eventual return to prime funds depends on two “wildcard” conditions. One is the amount banks choose to pay on deposits, currently close to zero, and the second is whether the yield spread between government and prime MMFs widens.
How the first plays out remains to be seen, but there are indications the yield spread will widen significantly. Mr. Carfang said that by the compliance date the spread had tightened to 8 or 9 basis points and the WAM for prime MMFs had shortened to around 15 days. Since then, the spread has since widened to around 13 bps while the prime WAM crept back up to between 20 and 25 days. The WAM of government and agency securities, however, is now more than 40 days.
“When prime gets back above 40 days, we’ll see prime MMF yields increase and the spread between prime and governments increase to well over 20 bps,” Mr. Carfang said. “If that spread increases to between 25 bps and 35 bps, then the flood gates will open and money will flow back to prime MMFs.”
Further widening that spread, some money will flow from government MMFs to bank deposits, requiring banks to offset that liquid asset on their balance sheets by buying more government securities, depressing their yields.
“So there’s some interesting interplay: As money moves into bank deposits and reduces yields for government MMFs, that dynamic could make prime MMFs more attractive,” Mr. Carfang said.
Brandon Semilof, managing director at StoneCastle Partners, agreed that corporates will start looking for options outside of government MMFs to pick up yield and diversify holdings, but they won’t be prime MMFs. He noted that a study conducted by Bank of America Merrill Lynch in June found that most corporates had no interest in moving back into prime MMFs.
The study’s authors said they were surprised by the large majority of respondents who said that 50% or less of prime outflows would return to the product within 18-to-24 months of the October rules implementation, “even if offered attractive yields.”
“A stable NAV and daily liquidity have been the main reasons for investing in prime MMFs,” Mr. Semilof said. “If I offer a cash management tool where the NAV fluctuates daily, there’s the possibility of gates preventing the redemption of funds for 10 consecutive days in any 90-day period, and there may be a 2% fee on assets to discourage redemptions – few corporates would be interested in that.”
He said that the fluctuating NAV makes it difficult to manage working capital and operating cash, since a corporate submitting a sell order won’t know what its proceeds are until the NAV is struck. Gates and fees provide a similar uncertainty.
“Taking principal risk with working capital operating cash is an oxymoron—it can’t happen. From what we’ve heard, no matter what the yield on prime MMFs, they’re not going to see money return,” Mr. Semilof said. He added that StoneCastle’s structured deposit, the Federally Insured Cash Account (FICA) program, provides institutional investors with access to screened banks in one account and now exceeds $10 billion.
Mr. Carfang said the “mere possibility” of a fee or gate shouldn’t deter corporates from returning to prime MMFs, given they already deal with fees and gates on other short-term investments. For example, they already face fees on CDs, for which early withdrawals result in a forfeiture of some accrued interest, and if a bank fails and the FDIC can’t resolve the situation overnight deposits will be frozen, similar to a gate.
“Similarly, if a corporate owns a big block of CP and needs to sell it immediately in a stressed market, it will have to take a haircut,” Mr. Carfang said. “That’s how the market works.”
Mr. Semilof said corporates wouldn’t invest cash needed for working capital or operating cash in longer-duration investments such as CDs to begin with, since they violate the requirement of immediate liquidity.
“Cash is the life-blood of an entity, allowing it to operate on a day-to-day basis but also build to support strategic purposes, whether M&A or some other strategy to enhance revenues,” Mr. Semilof said, adding that prime MMFs are simply no longer an appropriate vehicle for the working capital, operating cash bucket.
Treasury Strategies sent a comment letter to the SEC in 2011 that argued against a floating NAV. Since then, however, the IRS has greatly simplified the accounting by allowing institutions to book the changing values in other comprehensive income rather than earnings. In addition, the ability of the funds to retain amortized cost accounting on securities maturing in 60 days or less significantly narrows that band in which the NAV could fluctuate. The prime MMFs will still have to be marked to market on certain accounting period closings, Mr. Carfang said, but a loss of a few bps is minor compared to the additional yield offered by prime funds.
“Once we settle into the new equilibrium spread between prime and government MMFs, treasurers will be hard-pressed to say the new accounting is not cost justified,” Mr. Carfang said. “I can’t imagine a treasurer going to the CFO and saying it will take me an extra 10 minutes a day to deal with this, so I’d rather give up $5 million a year in yield.”
Mr. Semilof posed a contrary scenario.
“If a company’s CFO says treasury must redeem funds to support an acquisition that must be closed today, and the treasury comes back and says only 99.9% of funds are available due to rate fluctuations, that treasurer will be out of a job,” he said.
Prime MMFs may return to vogue among corporate treasurers, but to a lesser extent, said Lance Pan, director of investment research and strategy at Capital Advisors, which specializes in institutional cash investments, especially in the form of SMAs. He said Capital Advisors’ funds moved out of prime funds and into government funds in July, and talks with corporate investors suggest no hurry to move back into prime.
“From our discussions, investors who have moved out of prime funds aren’t looking to return anytime soon,” Mr. Pan said, adding that durations remain short, depressing yields and prompting some fund managers to waiver fees to make their funds more attractive.
Higher yields will like draw some corporate cash back to prime MMFs, but it may take awhile because once corporate boards have made decisions, they wary about reversing them, Mr. Pan said, adding that the board of one client that moved to government MMFs from prime MMFs in 2008 still refuses to go back.
And when they do come back, it probably will be for different reasons.
“They won’t consider prime MMFs as pure, daily liquidity vehicles. They might put a portion in government MMFs and the rest in prime funds that have some term feature to them,” Mr. Pan said.