Opportunity Knocks at the Short End

11 Oct 2016

Key takeaways

  • New rules that govern institutional money market funds take effect this Friday
  • Variable NAVs will become the order of the day; and money market funds will have the ability to erect gates and charge liquidation fees
  • Approximately $1 trillion has moved from prime money market funds to government money market funds
  • The sharp rise in money market yields makes for an unusual investment opportunity

Full commentary

Being a risk manager, and therefore not being tied with a short string to the immediate profit and loss (P&L) consequences of market movements, I sometimes have the luxury of taking a step back from the minutiae of markets and focusing on a market segment that lies out of the spotlight. The market I have in mind this week is the money market, in particular, the market for commercial paper, which is distributed to investors in large part via prime money market funds.

After the Reserve Primary Fund broke the buck in September 2008 on account of its holding 1.5% of its assets in Lehman Brothers CP, contributing to a near-freezing of the money markets that was solved only by the Treasury’s guarantee program for money market mutual funds, the Securities and Exchange Commission (SEC) took a keen interest in money market funds, and in 2014 adopted new rules for money market funds held by institutional investors. These rules, which go into force at the end of this week, allow for liquidity fees and redemption gates, and require institutional prime and municipal money market funds to move from a stable $1 price per share to a floating net asset value.

Institutional investors have not waited for the new rules to go into effect. They have voted with their feet, and have transferred around $1 trillion in assets from prime money market funds to government funds, which are still allowed to trade at a fixed $1 NAV, and which may (but are not require to) impose gates and redemption fees on investors in times of stress. The impact on money market yields has been electric. Commercial paper yields have risen steadily from their lows in 2014, and the 270 Day Dealer Commercial Paper Index now yields more than 5 year U.S. Treasury debt, a situation that last occurred in December 2012. It is worth noting that there are plenty of high quality issuers whose yield exceeds that of the index.

The 5 year Treasury yield and the 270 Day Dealer Commercial Paper Index have tended to track each other over time, with money market yields falling in concert with other short term yields when the Federal Reserve (Fed) eased. The clear advantage, from a total return perspective, in the past has been to durated assets, both on account of their roll down and the fact that we have been in a bull market for interest rates since 1980. But now the shoe is on the shorter foot.
The economy shows increasing signs of strength (in spite of last Friday’s 156,000 payrolls number which was slightly under the market’s expectation of 172,000). The Philadelphia Fed’s Aruoba-Diebold-Scotti Business Conditions Index, which hit a short term low of -0.3 in late August, has since recovered to -0.1. Suggesting that the economy continues to expand, though at a slightly slower rate than it has done over the long term. The Fed is under increasing pressure to raise rates at its December meeting, and the futures market is pricing in a 64% probability of a December hike.

It is rare that investors can reasonably expect to earn a higher return from money markets than from durated assets, but this is one of those times. Additionally, the return of money markets will almost certainly be less risky (as measured by volatility of returns) than that of 5 year Treasuries. The excess return being offered is entirely the structural changes in an important segment of the market, and a sea change in the mechanism of financial intermediation. It is not obvious to me that it will persist: companies, logically, will look for other ways in which to meet their short term funding needs. Meanwhile, investors should open the door: It’s opportunity we hear knocking!

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