Published: June 01, 2008
Since August 2007, the financial markets have been roiled by distress in the U.S. sub-prime mortgage sector, volatility in the ABCP markets, illiquidity and ratings downgrades. Fund sponsors have responded to the crisis in a variety of ways, depending in part on the nature of the funds in question. In an effort to minimize the impact on the credit quality of the portfolios and volatility in the net asset values of the funds they manage, and in the absence of liquidity, sponsors of constant net asset value (NAV) money market funds have generally started communicating with fund investors more frequently and have built up the liquidity positions of the funds they manage. They have done so in an environment of generally positive net cash flows.
Sponsors of constant NAV money market funds, without exception so far, have also provided some form of support to these funds as required. When it has occurred, fund sponsor support has served to protect investors in constant NAV money market funds from the effects of credit losses or losses stemming from the forced sale of illiquid assets or both. Such support has taken various forms, including capital support agreements, indemnities, provision of liquidity and the outright purchase of distressed securities from funds.
Although it is too soon to draw any firm conclusions about the ultimate impact of the crisis on the European constant NAV money market fund sector, the outlines of a few trends may be emerging.
Emerging trendsFor example, consolidation in the industry may accelerate in the wake of the crisis. The business of fund management is characterised by economies of scale. The cost of the infrastructure, both human and otherwise, needed to manage constant NAV market funds is material but the incremental cost is often negligible. This, coupled with the relatively low management fees the asset class attracts, has long given large funds an advantage over smaller ones. Further, the need to improve information technology and risk management had already been pushing costs upward. During the crisis, as noted above, a number of fund sponsors provided one or another form of support to their constant NAV money market funds. The cost of doing so, coupled with rising information technology and risk management costs, may make some fund sponsors, particularly mid-sized ones, reassess the attractiveness of their liquidity businesses. To the extent that they decide to exit as a result, consolidation may increase.
The range of constant NAV money market funds on offer in Europe is also likely to increase. In a flight to quality, investors have reduced their exposure to equities and riskier fixed-income funds while increasing their exposure to constant NAV money market funds. A number of investors have expressed interest in investing in even lower-risk constant NAV money market funds and so, for the first time in Europe, we have seen the emergence of so-called ‘Treasury-style’ constant NAV money market funds. These funds invest in either government bonds or reverse repos secured by government bonds. To date, Moody’s has rated three such funds - the BGI Euro Government Liquidity Fund, the JP Morgan Euro Government Liquidity Fund and the Goldman Sachs Euro Government Liquid Reserves Fund - and we expect to rate others in the near future. While investor fears are likely to subside over time and, if they do, interest in low-risk Treasury-style constant NAV market funds may wane, Treasury-style constant NAV money market funds are unlikely to disappear from Europe altogether. In the U.S., for example, Treasury-style constant NAV money market funds exist comfortably alongside Prime constant NAV money market funds and attract assets from highly risk-averse investors. Collectively, they account for about 13% of U.S. constant NAV money market fund assets under management. [[[PAGE]]]
Increased investment in reverse repos on the part of Prime offshore Eurodollar- and Sterling-denominated constant NAV money market funds is another likely consequence of the crisis. Prior to the crisis, investment in reverse repos, a type of secured lending, on the part of Euro-and Sterling-denominated Prime offshore constant NAV money market funds was negligible. Its absence from these funds contrasted sharply with its importance in the portfolios of US-denominated Prime constant NAV money market funds; as noted in our May 2008 Special Report entitled “Portfolio Management Activities of Large Prime Money Market Funds”, as of December 31, 2007, 14 large US-domiciled constant NAV money market funds tracked by Moody’s had invested 14.3% of assets under management in reverse repos. Offshore Euro and Sterling constant NAV money market funds typically invest less than 1% of assets under management in this asset class. Reasons for the lack of interest in reverse repos cited by European constant NAV money market fund managers include low yields and operational complexity. However, as the emergence of Treasury funds indicates, European constant NAV money market fund managers are developing an interest in reverse repos as an asset class and they may well begin to find their way into Prime as well as Treasury money market portfolios.
Other changes in portfolio investment are likely to emerge as well. Prior to the crisis, European constant NAV money market funds had invested a substantial proportion of assets under management in asset-backed commercial paper. While many fund sponsors continue to invest in this asset class, albeit sometimes at reduced levels, others have ceased investing in it altogether. Those that continue to invest generally purchase securities issued by large, bank-sponsored, multi-seller programs. Those that do not have increased their investment in bank deposits and unsecured commercial paper. Overall exposure of constant NAV money market funds to financial institutions, always high has, if anything, increased. Fund sponsors have also increased the amount of overnight liquidity they hold, in order to be able to meet investor redemptions without having to sell assets. While some of these developments will undoubtedly reverse over time, it is likely that the investment profile of constant NAV market fund portfolios will reflect high exposure to financial institutions and reduced exposure to some types of asset-backed securities for years to come.
European constant NAV money market funds have weathered the crisis of 2007 well so far but, not surprisingly, the continuing unsettled market conditions have had a profound impact on the way their fund sponsors manage them. Furthermore, while a number of credit issues have been resolved or are nearing resolution, others still remain outstanding. Fund sponsors and investors will continue to feel the repercussions of the crisis in the months and years ahead.
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