This past Friday, October 14th, commenced federally mandated rules on money market funds – what we typically think of as cash in our investment accounts – and marked the end of the era of prime money market funds.
Money market funds first came about in 1971 at a time when banks were prohibited from paying an interest rate on demand deposit accounts, and for those old enough to remember, you got a toaster or a clock radio as incentive to put money in checking accounts. Money market funds created an interest-bearing alternative to bank accounts; now, neither earns anything worthwhile.
The recent sweeping SEC reforms on money market funds has bifurcated the money market space by distinguishing between institutional and retail money market funds.
The rules create new definitions for retail money market funds which in essence become U.S. Government or Treasury money market funds. For institutional prime (general purpose funds that invest in corporate debt securities in addition to government securities) and municipal (tax-exempt) money market funds, these funds now have more onerous structural changes and are required to price and transact at a floating net asset value (NAV).
The rules were enacted in response to the impacts on the front-end of the yield curve during the financial crisis of 2008 (front-end being debt securities that mature within a year or less). 8 years in, the SEC is finally implementing changes to money market funds in order to make them more liquid, more transparent, and less risky.
Retail funds now have lower weighted average maturity requirements with fund assets being invested in only the shortest of duration government securities. (As I’ll touch upon later, there are perverse ramifications to the front-end that these rules are causing, affecting the global banking system and $7 trillion of debt, but first back to money market funds).
For those with individual brokerage accounts and retirement plans such as 401(k) plans at well known custodians (Fidelity, Schwab, etc.), they have most likely transitioned you to an appropriate fund so there’s no action for you to take. Without knowing your particular circumstances, your core money market fund is probably now Government and/or U.S. Treasury based. Given those investment instruments (short-term U.S. Government securities), you won’t earn any real interest on the account, but you won’t lose any money on it either (you will lose purchasing power in real versus nominal terms though).
For institutional money market funds and retail municipal (tax-free) money market funds, there will be liquidity fees and redemption gates that will penalize investors attempting to sell shares of a money market fund during periods of extraordinary market stress, and possibly make it so that investors are unable to redeem shares at all.
Thinking back before the financial crisis, money market funds weren’t just a place to park cash, they would also produce a low but dependable yield, and in some cases higher. In the good old days, money market funds offered decent yields by taking on some credit risk and investors got a free lunch by not having to take on that credit risk because they got a stable NAV – investors always got their principal back, never breaking a buck.
I remember back in the ’90s analyzing money market rates and purchasing prime money market funds for clients based on yield and other characteristics such as taxable vs. tax-free. Certain funds might be offering yields of 4.0%, others nearing 6.0% or more. Money market funds were an asset class (cash equivalents) that earned you something acceptable; how times have changed.
Money market yields are the equivalent of risk-free rates of return – a very important component to finance academics in Capital Asset Pricing Model (CAPM) and Modern Portfolio Theory (MPT) models. When the risk-free rate of return is close to zero or negative, CAPM and MPT results go out the window. At a yield of 0.1%, on a money market balance of $100,000 you’d earn $100 annually. Using the Rule of 72, you’d approximately double your investment in 720 years!
The SEC reforms had good intentions and are aimed at buttressing a $2.7 trillion market for money market instruments that exacerbated the financial crisis given credit-sensitive investments in subprime, collateralized debt obligations (CDOs) and mortgage-backed securities (MBS) as funds reached for yield. However, the new regulations are causing turmoil in money markets as big banks adjust to the new reality of a shrinking pool of available funding as prime money market funds were an important source of short-term funding for banks.
A key benchmark for the short end of the yield curve is called Libor – Libor being the benchmark rate that big banks charge each other for short-term loans (wholesale funds on an unsecured basis) and is used to calculating interest rates on trillion of various loans such as variable-rate mortgages, student loans, and corporate borrowings in addition to financial contracts such as swaps and futures. Easily, over $7 trillion of debt is pegged to the Libor benchmark.
Not since the financial crisis of 2008 has Libor experienced such a surge in rates. The three-month U.S. dollar Libor rate has jumped from 0.61% at the beginning of the year to 0.88% currently (a 44% rise) ahead of the money market reform due date (as shown in the Bloomberg graphic above, dated October 13th).
Over the past few months in response to the reform deadline, approximately $1 trillion worth of assets have shifted out of prime money market funds into government money market funds that invest in safer assets such as short-term U.S. debt, according to Bloomberg estimates. The exodus has driven up Libor rates as banks, in particular, and other corporate entities compete to find new sources of funding as prime money markets were the largest buyers of bank commercial paper (CP) and certificates of deposit (CDs). Some banks will re-price their CDs at higher rates to attract new investors.
In the past, a rise in Libor typically coincided with a waning perception of bank creditworthiness. Now; however, the current move is a re-pricing of risk during a handoff in the front-end wholesale funding markets from prime funds to a potential new investor base.
The changing landscape at the front end of the yield curve does offer potential opportunities for short-term oriented investors/savers who don’t mind a fluctuating NAV and some credit risk in search for higher yielding opportunities. My caveat here is that without knowing your circumstances, I’d seek the guidance of an investment professional as to what’s best for you.
Retail investors will continue to earn de minimis yield on their new protected government funds, but for those yearning for more yield, they may want to consider taking advantage of this shift higher in Libor by investing in assets tied to Libor rates, such as floating rate notes, term CP and CDs. Short-term and ultra-short bond funds look attractive, especially with three-month Libor now yielding more than two-year U.S. Treasuries (0.88% versus 0.83%, as of October 14, 2016). Many of these short-term funds are out-yielding longer-duration bond funds, creating a unique opportunity for some.
If you are looking for ways of generating income in a low interest rate world and, now, a more regulated one, please let me know as I’d be happy to discuss options that are available to you.
Prime money market fund as we knew them are gone after a 45 year run. And with interest rates finally starting to tick up after nearly 10 years, federal regulation has found a way to ensure that retail money market participants won’t get better returns all in the name of safety, ensuring no risk, no return.