Last week’s unveiling of the long-awaited new rules governing money market funds prompted a flood of commentary from the fund industry and reports from the financial press in a matter of just a few days. This month, we wish to focus specifically on how we believe the changes will have profound ramifications on all short-duration fixed income investors, and not just shareholders of money market funds. We plan to address the rules’ impact on the money fund industry in a later article.
Highlights of the New Rules
In a live presentation delivered by Mary Schapiro, chairwoman of the Securities and Exchange Commission (SEC), she re-affirmed most of the key amendments announced on June 24, 2009 to the existing so-called 2a-7 rules with some modifications. The industry still awaits the full document of the new rules, and we highlight the relevant items germane to our discussions here.
- A fund must keep at least 10% of its portfolio liquidity overnight and 30% within seven days. U.S. Treasury securities and certain other government securities qualify as liquid assets.
- The allowable bucket for illiquid securities is reduced to 5% of the portfolio from 10%.
- Investments in securities rated second tier (A-2/P-2/F2) are reduced to 3% of the portfolio from 5%. Exposure to an individual issuer is reduced to 0.5% from 1%.
- The maximum weighted average maturity (WAM) is reduced to 60 days from 90 days. The maximum weighted average life (WAL), a new limit measuring average final maturities, is set at 120 days.
- Collateral of repurchase agreements (repos) qualified for “look through” treatment must be cash items or government securities.
Expected Capital Markets Impact
As can be expected, the new rules intend to make money market funds safer by reducing maximum credit, liquidity, and allowable interest rate risks. Because the fund industry represents a very substantial part of the investor base for money market debt, we believe the new rules will have a tangible impact on the supply and demand dynamics of this market. We estimate that non-government money market funds make up 57% of the short-term debt market based on the $3.22 trillion in the size of the market and the $1.83 trillion in total assets of non-government funds. Such impact may include higher demand and lower yield for shorter and higher quality securities and lower demand and higher yield for longer-term, lower-quality paper.
Reduced Yield Potential: All else being equal, yield potential on money funds is likely to drop, at least in the near term. As funds shorten up their WAM and WAL, they will be forced to purchase securities with shorter maturities, which typically offer lower yield. Increased exposure to Treasury securities also will have a similar effect of lowering portfolio yield. The increased demand by money funds for sought-after shorter bonds and government securities may drive the yield on these securities down further, leading to lower yield potential for all cash investors.
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