This book provides chief financial officers and corporate treasury executives with an overview of changes in the cash investment landscape and a guide to more effective hands-on management of corporate cash portfolios. Its three chapters explain: 1) why many investment managers are migrating to separately managed accounts (SMAs); 2) what investment policies for cash management are needed; and 3) how credit and risk factors come into play in this new era.
As the economy improves and interest rates move higher, treasury professionals hoping for a return to the good old days of decent yields in safe investments are finding a new and different world. Today’s cash investment landscape is shaped by higher risk awareness, more sensitivity to liquidity costs and stricter systemic regulation. Dodd-Frank banking reforms, Basel III accords and other regulatory changes have made uninsured bank deposits less attractive than in the past. At the same time, money market fund reforms are expected to increase risk and reduce yields, lessening the attractiveness of institutional funds that previously were regarded as highly reliable, safe and stable investment vehicles for corporate cash.
Taken together, these changes are ushering in a new era in cash management. Treasury professionals increasingly are considering alternatives for managing cash, beyond bank deposits and money market funds. In a return to the direct management approach many abandoned in the 1990s, a large percentage of cash managers are planning to supplement their portfolios with direct purchases of marketable short-term securities in separately managed liquidity accounts. In short, now is the time to start rethinking cash investment strategies.
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Money Market Fund
The Transformation of Corporate Deposits in a New Regulatory Environment
Abstract
Bank deposits have always represented the main cash management vehicle for institutions. Growth in deposits and money market fund balances crisscrossed each other over recent decades. Recent financial regulations, notably the liquidity coverage ratio, net stable funding ratio and G-SIB capital surcharges, caused deposit dynamics to change, reducing banks’ appetite for non-operating deposits. We offer seven practical tips to help treasury managers cope with the new deposit reality.
Seven Tips to Cope:
- Deepen existing relationships
- Diversify
- Size still matters
- Integrated counterparty risk assessment
- Liquidity is the name of the game
- Alternative liquidity vehicles
- Beware of higher interest rates
Introduction
For centuries, businesses and individuals used banks for the majority of their financial transactions. The creation of the Federal Reserve System in 1913 and the Federal Deposit Insurance Corporation (FDIC) in 1933 gave the United States one of the strongest, safest and most trustworthy banking systems in the world. It is no surprise that treasury organizations rely heavily on deposits as their primary liquidity management vehicle.
The two decades before the U.S. financial market crisis of 2008 can be characterized as a period of rapid deregulation and disintermediation along with waves of bank mergers. The subsequent dramatic re-regulation to reduce systemic risk presents new challenges to corporate cash investors. On the one hand, transactional deposits become less profitable for large banks, which motivates the institutions to move them off balance sheet or impose stiff fees. On the other hand, institutional prime money market funds, a popular alternative cash vehicle, must adopt floating net asset values (NAVs) and optional redemption fees and gates by October 2016, limiting their utility as liquidity tools.
With these concerns in mind, we seek to help corporate treasury professionals to refocus attention on the mundane world of transactional deposit relationships, understand the current market dynamics, and carve out a balanced approached to cash investment solutions.
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Staying Afloat in a Floating Net Asset Value Money Market Fund
Abstract
This commentary addresses a number of liquidity challenges concerning institutional prime money market funds after October 2016. The floating net asset values, the provision of fees and gates and the institutional shareholder syndrome each presents a unique set of challenges. The reformed institutional prime product can remain viable for a certain population of current institutional shareholders, but we suggest a more comprehensive lineup of liquidity vehicles that include government and prime funds as well as individual government and other liquid instruments of laddered maturities.
Introduction
It is fall of 2016. The dust has settled on money market fund reform. Institutional prime money market funds have adopted floating net asset values (NAVs) with optional liquidity fees and gates provisions. Institutional investors demanding NAV and liquidity certainty have eschewed the product for other liquidity options. Will floating NAV funds retain a critical mass to stay afloat as a viable cash management tool? How will fund dynamics be different? For remaining shareholders, what are the liquidity challenges?
Assets in institutional prime funds more than doubled in less than a decade after the start of the new millennium, from $496 billion in 2000 to $1.1 trillion in 2009. For the first six months of 2015, fund balances dropped from $1.0 trillion to $968 billion1. For a liquidity product that will undergo dramatic structural changes as prescribed by the 2014 SEC rule amendment, little is known about the liquidity characteristics of the institutional prime fund come October 2016.
Our baseline assumption is that there will be a meaningful core base of corporate cash investors who will continue to use institutional prime funds based on economic, relationship or risk management reasons. In this paper, we will address a few liquidity concerns resulting from the forthcoming changes to institutional prime funds.
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Demystifying Asset-Backed Commercial Paper
Executive Summary
ABCP can still be a good investment choice in large corporate treasury accounts due to the liquidity, flexibility, and yield potential of the asset class.
Most traditional multi-seller conduits persevered through the recent financial crisis. Despite low issuance and investor skepticism, the mechanism of ABCP structures improved due to new regulatory measures.
Potential investors should carefully review the strength and type of the sponsor, external support, program type, and asset collateral quality prior to investing.
The wide range of risks among different programs requires specialized credit knowledge and regular asset collateral monitoring to minimize risk.
Introduction
Created in the mid-1980s, asset-backed commercial paper (ABCP) trailed its term asset-backed securities (ABS) cousin in acceptance by fixed income investors, especially corporate cash managers. The stigma against ABCP started to fade in the new millennium, when event risk of corporate names caused the unsecured commercial paper market to shrink dramatically.
Meanwhile, increasing demand from institutional investors for this asset class resulted in the proliferation of innovative ABCP structures that made it more difficult for buyers to discern risk among various programs. Despite that, the market grew rapidly to reach its peak in July 2007, when ABCP outstanding stood at $1.2tn.
Liquidity concerns following the onset of the subprime mortgage crisis pummeled the ABCP market, complemented by the fact that ABCP and the more exotic, now infamous, structured investment vehicles (SIVs) shared some structural similarities. After the Lehman Brothers bankruptcy in September 2008, outflows from prime money market funds, the predominant buyers of ABCP paper, intensified and directly resulted in the reduction of programs outstanding by ABCP sponsors.
As of August 5, 2015, total ABCP outstanding stood at $224 billion, a reduction of 82% from its 2007 peak. By comparison, overall CP outstanding was reduced by 52% to $1.07 trillion over the same period. Two main factors contributed to the reduction in ABCP outstanding, the deleveraging of banks’ off-balance sheet activities and regulatory pressure.
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Looking Beyond Bank Deposits and Money Market Funds
Abstract
Greater vigilance is required of today’s treasury investment professionals. Neither bank deposits nor money market funds may be appropriate in the post-crisis, post-regulatory environment. As yields start to rise, cash investment strategy decisions that may have been delayed will require serious consideration. Direct purchases in separately managed accounts may become the primary alternative cash strategy. A framework of stratifying one’s cash balances by liquidity objective is discussed.
Introduction
Remember Broadhollow Funding and Ottimo Funding? Eight years ago this month, credit woes at the two subprime-tainted commercial paper issuers marked the beginning of the turmoil that fundamentally changed the financial world. As the economy improves and interest rates move higher, treasury investment professionals may be expecting the good old days of decent yields in safe investments, but a new and different world awaits us.
Today’s cash investment landscape is shaped by higher risk awareness, better understanding of liquidity costs and stricter systemic regulation that requires new thinking in corporate cash investment strategies. Interest rate changes may be cyclical, but bank and money market fund regulations are likely to leave a long lasting structural impact. Taking the longer view, the sensible treasury investment manager may need to look beyond current practices for other cash investment alternatives.
In this commentary, we reintroduce some of our thoughts on cash investment strategies with the understanding that bank deposits and money market funds alone may no longer be sufficient cash management tools after new regulations are fully implemented.
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Six Advantages of Separately Managed Accounts
Executive Summary
The complementary use of commingled and separate accounts may help in optimizing corporate cash management.
The percentage of corporate investors considering money market funds as permissible investments has been declining since 2009, while the permissible use of separately managed accounts has been climbing.
Six Advantages of Separately Managed Accounts:
- Tailored Risk Management
- Transparency
- Higher Return Potential
- Free from “Hot Money”
- Income and Capital Gains Management
- Versatile Reporting
Investments in time and research in a separate account relationship may bring just rewards in times of uncertainty.
Introduction
One of the lessons corporate treasurers learned from the recent financial crisis is that, despite their appearance of safety and liquidity, pooled liquidity vehicles, including money market funds, are susceptible to lapses in investor confidence that may lead to runs. In 2007, after early blowups of supposedly conservative “yield-plus” and “ultra-short” funds, several state-owned local government investment pools (LGIPs) froze redemptions due to investments in troubled structured investment vehicles (SIVs). The Lehman Brothers bankruptcy in 2008 forced the $64 billion Reserve Primary Fund to “break the dollar,” the second such instance in the history of money market funds. The U.S. Treasury had to institute an emergency guarantee program to prevent widespread runs on money funds beyond the four fund families that had already implemented fund freezes. These events evoked uneasiness among treasury professionals who routinely used commingled investment vehicles as mainstay cash management tools.
Since we revised the original paper of the same title in December of 2008 and again in May of 2012 the Securities and Exchange Commission (SEC) implemented new rule 2a-7 requirements 2014, effective in 2016, which will do away with the constant net asset value (NAV) for institutional prime funds, and also mandate that fund sponsors institute gates or fees under certain conditions. Not surprisingly, the money market fund industry and many institutional shareholders pushed back fiercely, suggesting that these potential reforms could result in a substantial reduction of money fund assets.
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The 60-Day Prime Fund – A First Look
Abstract
As the money market fund industry moves to comply with the SEC Rule 2a-7 amendment, the 60-day maximum maturity prime fund concept has received much public attention. For institutional cash managers faced with a chasm between government and prime funds, the 60-day prime fund may represent a viable middle ground and a market-based solution to price the economic costs of stable NAVs and liquidity fees and gates.
While we like the concept in theory, a number of issues need clarification, among which is the challenge to the $1.0000 goal post with basis point rounding. Some of the other considerations include marketing challenges, the continued presence of liquidity fees and gates, supply constraints, yield trade-offs, intermediaries’ participation and regulators’ responses.
Introduction
With 18 months left before the 2014 money market fund reform takes full effect, a number of large fund sponsors have announced their fund lineups and follow-up strategies. In a February 19 press release, Federated Investors disclosed that it plans to convert “certain existing institutional prime funds to 60-day maximum maturity funds.” The main objective is to continue to offer a “stable” net asset value (NAV) product after institutional prime funds adopt market based NAVs come October 14, 2016.
We found this 60-day prime fund concept intriguing. As corporate treasury professionals start to look more closely at the various alternative liquidity solutions, we will attempt to shed some light on the features, potential applications and challenges of this new product. As the concept is still in development at a number of fund companies, there are more questions than answers today, in our opinion. We may return to the subject in a future installment.
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The Paths Forward
Abstract
As large money market fund sponsors begin to release their new fund directions, the wait may be over for cash investors to get their own strategies in place. The recent announcements allow us to gauge different paths forward for the industry and help investors gain insight into what to expect. Among a lineup of alternatives options, separately managed accounts may provide investors the necessary supplemental capacity to both satisfy liquidity needs and opportunistically take advantage of market dislocations. Nine things we learned from the recent announcements include:
- The most direct route to stable NAVs with no “fees and gates” is through a government fund.
- All existing funds and shareholders must reconfirm their identities.
- Look out for government funds that may opt in to “fees and gates”.
- A 60-day maximum maturity “stable NAV” fund is still a floating NAV fund.
- Fund sponsors go their separate ways in retaining existing institutional shareholders.
- Fund choices will be more limited, especially for municipal fund shareholders.
- Executing structural changes is time consuming.
- Changes may come several months before October 14, 2016.
- There are many choices, but no clear winners.
Introduction
Structural reforms on money market funds adopted by the SEC in July 2014 were widely expected to bring about comprehensive changes to the popular savings vehicle. Cash investors, especially shareholders of institutional prime funds, were anxious about a world of floating net asset values (NAVs), liquidity fees and redemption gates (fees & gates). For much of the last six months, they sat and waited for some information upon which they could act.
Now, the wait may be over.
Over the last month or so, three fund companies provided significant fund updates that may lay paths to a new world of liquidity investments effective October 14, 2016. Fidelity, JPMorgan, and Federated together manage $884 billion, or one third of the $2.7 trillion of U.S. money market fund assets, and rank as the 1st, 2nd and 4th largest managers by assets, respectively, as of January 31, 2015 . Thanks to their dominant market.
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Structured Debt Finance for Healthcare Companies
Note: For the purposes of this paper, we will define “healthcare” as life sciences/biotech, medical devices, diagnostics and health tech.
Capital Advisors Group is a Boston area-based institutional investment advisor that has been helping venture-backed companies invest their cash assets for more than 23 years. Its debt finance consulting division helps early stage companies, both public and private, determine their optimum capital structure, identify appropriate lenders, source term sheets and negotiate deals.
Executive Summary
There has been a noticeable shift over the past two to three years in how early stage healthcare companies finance their operations. The traditional model of seed stage financing followed by venture capital and, perhaps, some mix of bank or venture debt is becoming less and less the norm. It appears more difficult now to get ideas off the ground through traditional methods. We are now seeing a mix of creative structures that sometimes include venture capital syndicates combining for large early rounds. We are seeing large pharmaceutical companies partner with companies at earlier stages and licensing agreements or outright sales of programs in the clinic to finance other products in the pipeline. In addition, the debt financing landscape has been altered by new players in the market who have added to a growing source of funds for early stage healthcare companies and created increased competition among lenders.
The goal of this paper is to provide an update on the shifting landscape of the debt financing markets, ranging from bank debt to structured debt with a specific focus on how this structured financing has helped fuel an extremely competitive debt market.
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Looking Beyond Bank Deposits and Money Market Funds
Abstract
Greater vigilance is required of today’s treasury investment professionals. Neither bank deposits nor money market funds may be appropriate in the post-crisis, post-regulatory environment. As yields start to rise, cash investment strategy decisions that may have been delayed will require serious consideration. Direct purchases in separately managed accounts may become the primary alternative cash strategy. A framework of stratifying one’s cash balances by liquidity objective is discussed.
Introduction
Remember Broadhollow Funding and Ottimo Funding? Eight years ago this month, credit woes at the two subprime-tainted commercial paper issuers marked the beginning of the turmoil that fundamentally changed the financial world. As the economy improves and interest rates move higher, treasury investment professionals may be expecting the good old days of decent yields in safe investments, but a new and different world awaits us.
Today’s cash investment landscape is shaped by higher risk awareness, better understanding of liquidity costs and stricter systemic regulation that requires new thinking in corporate cash investment strategies. Interest rate changes may be cyclical, but bank and money market fund regulations are likely to leave a long lasting structural impact. Taking the longer view, the sensible treasury investment manager may need to look beyond current practices for other cash investment alternatives.
In this commentary, we reintroduce some of our thoughts on cash investment strategies with the understanding that bank deposits and money market funds alone may no longer be sufficient cash management tools after new regulations are fully implemented.
The Search for Alternatives Delayed but Not Forgotten
The vulnerability of a corporate cash management model based on money market funds and uninsured deposits was evident during the turmoil following the Lehman Brothers bankruptcy. However, the government’s subsequent guarantees on money market funds, bank debt and deposits delayed broader recognition of the faults in this model by several years. When the unlimited FDIC guarantees on transactional accounts expired in 2012, treasury investors still lacked the incentive to search for alternatives, as money market reform remained uncertain. The near-zero yield environment also made risk-reward tradeoffs of alternative strategies less appealing.
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Debt Financing for Healthcare Companies
Note: For the purposes of this paper, we will define “healthcare” as life sciences/biotech, medical devices, diagnostics and health tech.
Capital Advisors Group is a Boston area-based institutional investment advisor that has been helping venture-backed companies invest their cash assets for more than 22 years. Its debt finance consulting division helps venture-backed companies determine their optimum capital structure, identify appropriate lenders, source term sheets and negotiate deals.
Executive Summary
Capital Advisors Group’s debt finance consulting division (formerly Debt Advisors Group), was founded in 2003 with the goal of tracking the debt financing markets and helping early stage companies secure the most competitive deal terms and conditions available. The goal of this paper is to provide an update on the shifting landscape of the debt financing markets, ranging from venture debt to structured debt and “synthetic royalty” based financing.
A Brief History
Corporate debt financing has been around in one form or another for about as long as there have been companies willing to take loans (i.e. a long time). However, the concept of venture debt, intended for companies that did not qualify for traditional bank financing, has only been around since the late 1960s. These start-up companies not only lacked a proven track record, but also were burning through cash. Historically, the only way such companies could raise capital was through equity financing. Then, a number of equipment leasing companies that were well prepared to maximize the value of certain types of equipment as collateral, began underwriting short term operating leases (typically three years) to these early stage companies. In this emerging form of lending, venture debt was collateral driven and almost never reached the full 100% acquisition cost level for these cash-strapped firms.
In the late 1980s, Equitec Financial Group developed a leasing product that offered full equipment cost financing. Equitec devised the concept of using an “equity kicker” on each deal to increase yield on a portfolio basis to balance the higher risk profile of the borrowers and to offset the inevitable increased loss ratio when compared to bankable credit portfolios. In these early transactions, the “equity kickers” came in the form of success-based fees or warrants. As the years passed and early stage firms became more virtual and required less equipment, other lenders entered the space and were willing to use this proven structure without specific equipment collateral utilizing a lien on all the assets of the firm. Currently most “venture debt” is referred to as a “growth capital line” which can be used for any corporate spending purpose. The cost basis of these loans is typically based on a percentage of current liquidity. The loans are structured on a 3 – 4 year term with a lien on all the assets of the firm except the “Intellectual Property”, which is usually placed under a negative pledge.
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Maintaining Liquidity in Corporate Cash Accounts
Abstract
Separate accounts may offer greater return and reduced credit risk compared to prime money market funds. By examining current and future liquidity needs and the potential for significant deviations from cash flow projections, corporate treasurers may construct portfolios with direct investments in high-quality credits that satisfy current, future and emergency liquidity needs – and still may achieve higher returns than money market funds while eliminating the shareholder risk of pooled vehicles.
Introduction
Events of the past 6 years have shriveled yields for deposit and money market products, while at the same time increasing investors’ risk of both principal loss and interruption in liquidity. This year the SEC is expected to make a final ruling on the direction of Rule 2a-7, which could materially alter the utility and the yield potential of money market funds by introducing floating net asset values, liquidity gates, or some combination of both. Corporate treasurers who traditionally have maintained all of their cash in bank deposits or overnight products may be forced to examine other options to maintain a competitive (or merely positive) return and avoid incurring inappropriate concentrations of credit risk. A major hurdle in this process is satisfying the need for daily liquidity given businesses’ varying degrees of clarity with respect to future cash needs. Fortunately, with a carefully planned maturity structure and an organized strata of liquid investment vehicles, separately managed account portfolios (SMAs) can offer a high degree of liquidity that may satisfy most treasurers’ requirements.
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Making Sense of the Federal Reserve’s Reverse Repo Facility
Abstract
The Federal Reserve introduced the new reverse repo facility to control the level and volatility of short-term interest rates, to help relieve repo collateral shortage and to better regulate the tri-party repo market. The likely impact includes the avoidance of negative yield, the addition of a high quality counterparty to the marketplace, more responsive market rates to Fed policies and a flatter yield curve. These benefits are balanced with market concerns that the Fed may exert too much influence on capital markets and that it may crowd out securities dealers and lead to higher fund costs. A slowdown in the reduction of the Fed balance sheet is a concern, as well.
Introduction
The Halloween season began early this year with the financial markets full of tricks and no treats. In September, the Fed defied market expectations when it failed to announce a tapering of its asset purchase program. Then there was the political wrangling in Washington that led to a 16-day government shutdown and the threat of a Treasury default. The economic aftermath of the shutdown and presumably a Janet Yellen-led Fed in January all but guarantee that tapering is off the table until next March.
Given these conditions, a discussion of the Federal Reserve’s Reverse Repo facility, which first came into light in the July 31 FOMC minutes, seems out of place. After all, the facility was designed as a tool for the Fed to remove excess liquidity from its ballooning $3.4 trillion balance sheet. If we are not expecting asset purchases to slow down in the near future, why are we talking about the ways the Fed can reduce its balance sheet and the resulting impact this may have on short-duration cash investors?? In our view, the near-term effect of the facility may be muted, but the impact at the facility’s operational stage may be so immense that it could fundamentally alter all short-term interest rates and market supply/demand dynamics.
For those who are not engaged in or familiar with the mysterious world of repo markets, we wish to explain the new Fed tool in this research paper. Although many of us cannot “buy” repos from the Fed, many of the things we do buy may be forever changed by the facility once the Fed ramps it up to a meaningful size. Thus, it is worthwhile to understand how it works, its intended purposes and market implications, even though we may not feel its full impact for another 12 to 18 months.
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Capital Advisors Group’s Comments on the Recent Money Market Fund Reform Proposal by the Securities and Exchange Commission
Summary Opinion
Institutional Shareholder Perspective: We commend the Commission for tackling the tremendous task of analyzing mountains of data before putting forth the reform alternatives for public comment. We seek to weigh in on the subject from the perspective of an institutional asset manager.
Penny Rounding for Shareholder Activities: We support the mandatory daily disclosure of market-based NAVs as the published share prices and penny-rounded NAVs for shareholder activities. In our opinion, floating NAVs provide no more informational value than market-based NAVs.
Managed Stable NAV: If the basis point rounded NAV approach is adopted, we propose a NAV stability band between $0.995 and $1.005 beyond which fees and gates may be imposed. This approach provides tax and accounting justification for maintaining the funds’ current distinction and preserves some operational attractiveness.
Fees and Gates are a Non-Option: We view fees and gates as ineffective because of probable shareholder expectations that the tools will not be deployed due to fund sponsors’ self-preservation motives.
Cost Plus Penalty Redemptions: We propose an emergency redemption price of market-based NAV plus a 1% liquidity fee when thresholds are breached (defined as weekly liquidity < 30% or market-based NAV < $0.995).
Gates Most Undesirable: We are strongly opposed to the use of gates. However, if gates must be implemented, we propose allowing redemptions of up to 50% of remaining balances.
Explicit Sponsor Support: We propose making sponsor support explicit, committed and disclosed prior to an event occurring.
Background and Scope
We welcome the opportunity to comment on the Securities and Exchange Commission’s money market fund reform proposal. We express our thoughts from the perspective of an investment advisor that manages excess cash balances for more than 150 institutional and corporate accounts, the majority of which use money market funds as daily liquidity instruments. As such, we limit our comments to matters concerning institutional prime funds, not retail, government or tax-exempt funds. We commend the Commission for covering the bases on many of the subjects we are about to discuss. For brevity’s sake, we organize our views in a summary format without detailed reference to discussions in the proposal.
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Issues and Trends in Money Markets
Abstract
As we recap market developments in the first six months of 2013 and look to the future, we reflect on the following five observations from a recent liquidity conference:
- Low yield environment turning the corner;
- Corporate cash balances up, investors less worried;
- Supply still constrained, but more issuers entering the market;
- New money market fund proposal is here, but reform may be years away; and
- Portfolio strategies still defensive, but more diversified
Introduction
The first half of 2013 saw developments that may alter the cash investment landscape for years to come. As we hit the midpoint of the year, we reflect on some of the key trends that are either already in place or developing. Reflections from a conference organized by money market fund data publisher Crane Data held in Baltimore from June 19th through 21st help us identify and confirm such trends. We think that 2013 is an inflection point for short-term interest rates, supply and demand dynamics, and the regulatory environment, all of which will impact investor behaviors and portfolio strategies.
Looking back at the first six months of the year, we witnessed the expiration of the FDIC guarantee on large deposits, the “fiscal cliff” and the ensuing sequesters, deposit defaults in Cyprus, chatter about the Federal Reserve’s “tapering” of asset purchases and the culmination of the SEC’s money market fund reform proposal, just to name a few.
How will these events affect our market? Where do we go from here? What are the likely responses to regulatory changes? These were the questions on the minds of some 450 conference attendees, representing money market portfolio managers and salespeople, commercial paper issuers, securitization specialists, dealers, ratings analysts, attorneys and government representatives, as well as corporate and institutional investors.
In this credit commentary’s limited space, we attempt to summarize trends we’ve observed in the following five areas: short-term rates, corporate cash balances and investor behaviors, supply dynamics, regulatory development and portfolio strategies.
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