Published: April 10, 2013
The 2007-2009 credit crisis brought about fundamental changes in the landscape for money market funds. Not least of these is the role and importance of Credit Ratings Agencies (CRAs). Regulators responded to a pre-crisis perceived over-reliance on CRAs in the securities industry and by investors by proposing laws that would specifically prohibit the reference to issuer ratings in legislation. In turn CRAs amended their credit matrices, or the scoring process they used to gauge the credit strength of issuers and their various instruments, often resulting in a downward shift in their credit assessments of specific counterparties. From a number of perspectives it has become arguably less likely that CRAs will continue to play as significant a role for the money market industry as they have done up to this point.
In our view CRAs are important as an information point to the investment process for both asset managers and clients but should be viewed as just one component in a process that should include dialogue and partnership between an asset manager and a money market fund investor.
A confluence of factors has led to a difficult investing environment as cash investors seek to find balance between their quest for stability, liquidity and yield. In this article, we explore what the impact has been on money market funds (MMFs) and options that may help cash investors find relief in this challenging environment.
The current economic climate has caused investing in the short-term markets to be increasingly challenging. Whether for an MMF portfolio manager or a corporate treasurer investing directly in the markets, it has never been harder to invest cash assets whilst aiming to achieve flat or positive yields. This situation has arisen due to a number of factors:
1) Diminishing Supply: Over the last year there has been a decreasing supply of eligible money market instruments particularly from the banking sector, most notably in maturities under one year. This is primarily due to the two LTROs (Long-term Refinancing Operations) which have funded the banks for three years, meaning decreasing bank appetite for cash balances. In addition, there are pending regulatory changes - like Basel III - which incentivise banks to terming out their funding.
2) Credit Deterioration: It would be hard to not have noticed the plethora of ratings downgrades that have taken place in the last year. In fact, there is no longer a bank in the UK that carries an AAA rating, which has led to a single-A banking universe. Western European banks and financials in the investment grade space were downgraded at a rate of 22 to 1 by Moody’s in 2012. For Standard & Poor’s the figure is 10 to 1 over the same period. Many treasurers and MMFs have had to amend their investment guidelines by either reducing their % allocation to lower rated counterparties or by removing some counterparties from their approved list. Credit deterioration further exacerbates the challenges in supply due to these requirements.
3) Prolonged low interest rates: In July 2012 the European Central Bank (ECB) cut the deposit rate to an unprecedented level of 0.00%, with the UK also having the lowest interest rates since records began at 0.50%. Market indicators tell us that this yield environment is expected to continue, impacting investors in the short-term markets.[[[PAGE]]]
With a number of headwinds in play (low yields, Basel III regulation, the Bank of England’s preference for term funding, Eurozone government bonds volatility), the supply of high quality short-dated assets declined in 2012 and will be limited in 2013. Surely running an AAA rated Prime money market fund is prohibitively more difficult in this environment as the metrics used to evaluate and rate funds do not keep pace with the rate of downgrades. As a result of acting unilaterally in re-benchmarking the bank sector, the overlap between rated funds and eligible supply is disappearing. In order to be compliant, AAA-rated money market funds are being led into a smaller eligible universe.
With the number of non-governmental eligible securities significantly reduced, it leaves the option of sovereign debt as one alternative. However, with the amount of highly rated treasury debt reducing further, and sovereign ratings continuing to be challenged as the likes of the UK are put on negative outlook it makes getting invested even harder. There is also the opportunity cost that comes with investing in sovereigns in terms of yield sacrifice.
Therefore portfolio managers need to be creative and utilise all of their resources in order to search for additional options and yield.
CRAs somewhat constrain investment decisions due to the methodology that they employ. Ratings provide a great benchmark or reference point that investors use to evaluate a fund’s potential eligibility for the inclusion in their guidelines. Furthermore, without globally recognised standards, uncertainty about the credit quality of the investment could undermine the confidence of investors. However, the financial crisis brought into sharp focus a number of weaknesses in the CRA model. Regulators, globally, have sought to address these weaknesses and to modify investor behaviour by discouraging an over-reliance on ratings.[[[PAGE]]]
In the past CRAs have been proactive in changing their methodology in order to account for changing conditions; however they often take a significant amount of time to implement and so lag behind market movements. Additionally rating agencies have used a fairly mechanistic relationship between long-term and short-term ratings rather than providing standalone analysis for short-term ratings which would be decoupled from their long-term counterparts. We believe this would be a more productive outcome for short-term investors. Therefore it is prudent to think about funds that are not externally rated in these current market conditions. As without the constraints of a rating, MMFs can deliver potential yield pick-up over funds constrained by rating agencies’ guidelines while also relying on their internal extensive credit management process.
We believe it is time to reassess and update investment policies in order to take advantage of new investment solutions. After carefully considering risk tolerance, portfolio objectives and benchmarks, you can determine whether alternative solutions (i.e., unrated or lower rated funds) in the cash management space might work.
Questions for corporate treasurers to consider:
At BlackRock we consider external ratings as a preliminary screen in our own independent credit review; that is, we use the ratings as a ‘starting point’ in our assessment of an investment, formulating our own independent ‘credit opinion’ about an issuer or a specific investment instrument. Our assessment does not end when we purchase a security. Just as each rating agency may upgrade or downgrade issues, our credit analysts apply an independent assessment of each security throughout the period that we hold the security in a portfolio which includes monitoring rating agency changes.
In this constantly changing environment, investors are going to have to alter how they think about cash investing. Regulatory change is looming as well as fundamental changes to the way MMFs are operationally run. For cash investors, the past few years have seemed like a fight for survival. But there are ways to adapt to the new world, to make the shift from survival to revival. To thrive in this challenging environment, the fittest investors will be more nimble in their approach, more adaptive in their thinking, and more flexible in their search for opportunities.
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