Is the Future of Money Market Funds Hanging in the Balance?
by David Rothon, Senior Investment Strategist, Northern Trust.
Whilst recent opinion has been improving, the financial and economic backdrop remains fragile and uncertain. A complete meltdown of the financial system has seemingly been averted but the recessionary fire continues to burn brightly.
Across the globe, corporate profits have, for the most part, been disappointing and the negative impact of rising unemployment, a reduction in both capital spending and in inventories is hampering economic recovery. Corporates are facing significant challenges in working through this exceptional period. Treasury teams in particular continue to navigate through choppy waters, as counterparty lists have shrunk through rating downgrades, concerns continue about banks and other financial institutions, liquidity headaches remain, and there are fears over what assets are contained in their money market funds (MMFs).
Governments and central banks have alleviated some of these concerns by recapitalising institutions and injecting liquidity into the system to unfreeze markets and improve the price and availability of credit. Nevertheless, dislocations are widespread across capital markets. New policies, such as quantitative easing, are making the task of managing corporate cash increasingly more complex.
New policies, such as quantitive easing, are making the task of managing corporate cash increasingly more complex.
Managers of AAA-rated MMFs faced similar issues to those of corporate treasuries, both of which were stretched by a perfect risk storm of interest rate and credit spread widening, coupled with a sharp reduction in liquidity. To counteract these risks and ensure adherence to the core objectives of capital preservation and maintenance of liquidity, many fund managers kept investments short to reduce interest rate risk and to improve the maturity profile. However, by holding higher levels of liquidity and investing at the front of the yield curve, managers exacerbated the interbank freeze as borrowers found it increasingly difficult to source longer-term funding. Additional pressure came from MMF managers eager to reduce credit risk and bolster capital preservation. These managers, for the most part, shunned asset backed securities, corporate commercial paper and financials exposure in favour of government, agency and supranational exposure. Credit risk was a concern, but of greater concern was the ability to sell assets in order to meet investor withdrawals. When a run on a high profile MMF triggered an industry-wide run in 2008, the US Government intervened and provided a liquidity backstop to restore confidence. Today, the extreme dysfunction witnessed in the secondary market has not yet fully gone away, and a lack of liquidity remains one of the greatest risks for MMFs. Despite the recent easing of LIBOR levels, bid/offer spreads remain wide across most asset classes, causing funds to be cautious about investing further out on the yield curve.
Defining money market funds
A more sobering issue is the very future of the MMF industry in the wake of potentially increased regulation, more restrictive guidelines, and the requirement for constant NAV MMFs in the US to potentially hold a special purpose banking licence. The US Government in particular is concerned with the role played by MMFs during the credit crisis, in terms of systemic risk and financial stability. Before considering the future of MMFs, it is important to understand that several different types of money market funds exist, each exhibiting its own risk/return dynamics. Unfortunately, labelling of money market funds in Europe has frequently been misleading. There have been instances, for example, of short duration bond funds and enhanced cash funds being termed money market funds, when in reality they are distinctly different from AAA-rated treasury style MMFs. The definition provided by the Institutional Money Market Fund Association (IMMFA) defines MMFs as: “mutual funds that invest in short-term debt instruments. They provide the benefits of pooled investment, as investors can participate in a more diverse and high-quality portfolio than they otherwise could individually. Money market funds are actively managed within rigid and transparent guidelines to offer safety of principal, liquidity and competitive sector-related returns.”
Moreover, IMMFA implicitly distinguishes between treasury-style products such as constant NAV MMFs and investment style funds with a variable NAV. In fact, IMMFA has worked hard to create a transparent code of practice for money market funds in Europe as a way of differentiating true AAA-rated funds from other money market vehicles. This has proved necessary due to a number of high profile European based short-dated bond funds and enhanced cash vehicles that suffered losses following the credit rout, negatively impacting the perception of the money market universe as a whole.