The big day has finally arrived: starting today, as previewed repeatedly over the summer, the SEC's 2a-7 money fund reform adopted in 2014 officially requires many prime money market mutual funds (those that invest in non-government issued assets such as short-term corporate and municipal debt) to float their net asset value. More importantly, these prime MMFs are allowed to delay client withdrawals under adverse market conditions.
The rule aim to prevent the sort of chaos that hit the money market after Lehman Brothers Holdings Inc.’s 2008 bankruptcy, which helped spark the financial crisis. The goal is to give investors a way to monitor a fund’s health by tracking its fluctuating net asset value, and to contain the fallout that could be caused by many investors cashing out at once, the SEC wrote in the final rules.
As as result, many Prime MMFs are and have been converting their assets to government funds, not buying CDs anymore and moving into Treasurys and agencies. As the chart below shows, nearly $1 trillion in assets have rotated out of prime money markets into government funds, as a result sending Libor rates through the roof, to the highest level since the financial crisis, with consequences that have yet to be determined.
Average yields on government money funds are at 0.18%, according to Crane Data LLC. Prime money funds, by contrast returned on average 0.29%, while corporate bank deposits can earn anywhere from 0.15% to 0.30% at large U.S. banks, according to Mr. Klein, of Hightower Treasury Partners, cited by the WSJ.
While companies, pension funds and insurers have traditionally used prime funds as a place to park cash they need for routine purposes, such as paying bills, they are now looking at non-"prime" alternatives. The funds provided slightly better returns than a bank account with little risk.
“Historically corporate treasurers are tasked with investing in a way that they will preserve their principal,” said Jerry Klein, head of the corporate cash management group at Hightower Treasury Partners, an investment-management firm. “That’s one of their biggest concerns.”
As Wedbush's Scott Skyrm notes, while some large funds are likely converting this week, much of the impact has already been priced in by the markets. One thing that is not priced in is what happens to Libor in the future, and how it impacts the $7 trillions in debt that reference Libor.
Christina Kopec, head of retail-product strategy for global fixed income at Goldman, said the large move into government funds may be temporary, as corporate treasurers wait for things to settle down after the new rules take effect.
According to a Goldman report from last week, the trend toward higher LIBOR could eventually be partially reversed as banks develop alternative funding sources, but this process would likely take months to occur. Goldman expects short-end rates in general to be dragged up as the Federal Reserve resumes its hiking cycle and expects Fed Funds to reach 3.25%-3.50% by Q4 2019 pushing 3-month LIBOR to 3.6%, 275bp above current levels.
Others disagree, with banks such as DB and BofA both expecting Libor to decline in coming months as the rotation out of prime into government moderates, and as the recently profiled Japanese banks using CPs and CDs to fund themselves shift to alternative sources of funding, removing upward pressure from Libor.
To be sure, only time will tell if funding markets normalize and financial conditions ease for those who still rely on Libor rates as a benchmark for trillions in debt.
But aside from markets, and those who forecast and trade Libor, how are companies themselves responding to the new regulations?
According to the WSJ, the new money-market fund rules "have made life more difficult for corporate treasurers and chief financial officers" because they face a sometimes unfamiliar array of investment options as they seek both to preserve and earn some return on their collective trillions.
Take the case of Simon Gore, treasurer of budget carrier Spirit Airlines, who has had a relatively simple job over the past several years when he took tens of millions of dollars of company cash and parked it in money-market funds. Gore told the WSJ he has moved money out of some funds and is considering his options for depositing the more than $1 billion of cash and investments on Spirit’s balance sheet.
Gore had previously put almost all of Spirit’s cash in prime money-market funds. Now, he has shifted most of it to money funds that invest in debt issued by the federal government or agencies such as Fannie Mae and Freddie Mac, which aren’t affected by the new rules. He said the prospect of a floating net asset value - which also means client withdrawals can be delayed - caused him to think twice about prime funds. Besides facing the risk of losing money under the new rules, companies would have to record changes in the value of their cash, creating accounting headaches.
Others agree: that the treasurer for MGM Resorts International, Mike Carlotti who had previously put his company's cash into prime funds and bank accounts. The company, which had roughly $2.5 billion of cash at the end of June, has shifted out of the prime funds into government funds. “There’s no compelling reason to be in the prime funds,” he said. The yields on prime funds, while traditionally higher than government funds, are not big enough to justify staying in prime funds, given the hassles that the new rules introduced, he added.
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But while from a fund allocation perspective Prime funds have become less attractive, issuers of LIBOR-referencing debt don't seem to mind. As Bloomberg points out this morning, companies are issuing U.S. leveraged loans at an increasing clip, despite the increase in Libor.
Bloomberg asks rhetorically why these companies would keep issuing Libor-linked debt if they thought they'd be paying a materially higher rate in the near term? "Yes, they may opt to hedge their floating-rate risks through derivatives, and yes, they want to diversify their financing sources, but that's not the whole story. "
The proposed answer: "In many cases, they're still receiving a competitive rate in the loan market, even with the rising floating rate. That's because a growing number of investors have piled into this debt, with the goal of capturing bigger yields as Libor rises. This has meant that the extra spread above the benchmark has narrowed materially over the past six months, offsetting Libor's rise."
It also notes that aside from shifting allocations, companies don't appear to be particularly worried about Libor surging much further. The Fed doesn't seem keen to raise its benchmark rate all that much, and there will probably be some reconciliation between Libor and the fed funds rates at some point.
Meanwhile, at some point companies and investors will take advantage of the arbitrage available between prime and government funds, and likely revert to some pre-Oct 14 state:
The outflows may continue. But at some point, investors will start to return to these funds, attracted by the now higher yields, especially if other rates don't increase.
But perhaps the biggest red light is that at least as of this moment, while the Fed has indicated it's paying attention to Libor's rise, "it appears to have concluded that Libor's wrecking ball has already done most of its damage."
We all know what happens next.
Meanwhile, keep an eye on Libor: now that all the foreplay "rotation" between prime and government funds have largely concluded, what happens next will be critical. Should the levitation continue, it will suggest that the recent blowout in funding costs was more than just a regulatory quirk, and the sleuthing for what is really behind the tightening in financial conditions can begin in earnest, making the Ted-spread meaningful once again.