Money market funds hamstrung by regulations

Money market funds have a fundamental place in the global financial machine, supplying critical liquidity to governments, companies and banks. Around 38 per cent of short-term debt issued by banks and 20 per cent of short-term debt issued by European sovereigns and companies finds its way into these funds, according to the European Commission. Little wonder they attract such regulatory scrutiny.

The long awaited overhaul by the Securities and Exchange Commission (SEC)forcing prime money market funds to allow their NAVs (net asset values) to fluctuate based on the underlying value of the investments in the fund, rather than remaining constant at a $1 (€0.77) per share, is part of an attempt by regulators both in the US and in Europe to clamp down on the potential risk posed by a number of investors trying to withdraw money at the same time. However, it will hurt these funds which are already working hard to chase down attractive eligible paper and pay close to zero while their more flexible brethren pay around 20 bspts a year.

In Europe, the European Commission has proposed even tougher measures, such as that ‘constant net asset value’ money market funds should be forced to hold a cash buffer of 3 per cent, and minimum requirements for liquid assets,  of up to 10 per cent maturing daily and an additional 20 per cent within the week, further limiting the kind of investments that can be made.

The SEC has also forced through measures for gating these funds to discourage redemptions, warding off a rerun of the  flows logjam that followed Lehman. For example, if a fund’s liquidity drops below 30 per cent of total assets, its board can impose a redemption fee of up to 2 per cent, and can also impose a gate, for a maximum of 10 business days although funds will not be able to gate funds for more than 10 working days in any 90-day period.

Under current law, funds are already allowed to delay redemptions for up to seven days, or suspend redemptions after obtaining an order from the SEC, but the new changes have highlighted the potential hazard to investors.

The industry argues that tougher capital requirements have already hit its  profit margins, which are also contending with low interest rates on short-term securities. Publicly, however, the SEC proposals have prompted surprisingly little opposition, possibly because there is a sense that if the regulators can be persuaded to examine the issue in isolation, there is less chance they will regulate whole firms, potentially making some major players such as Fidelity and BlackRock “systemically important financial institutions”.

Money market managers have reacted to the diminishing universe by extending the average credit duration in their funds, according to a recent report from the Institutional Money Market Funds Association. For example, AAA-rated institutional money market funds denominated in EUR have progressively increased their ‘weighted average life’, from 45 days at the end of December 2013 to around 65 days as at mid-August 2014.

“These last months, euro money market rates have reached historical lows while euro short term credit spreads remaining relatively stable – after a slight widening observed around year end, credit spreads have slightly tightened this summer,” says Xavier Gandon, money market investment specialist  at BNP Paribas Investment Partners.

“In that context, money market portfolio managers have tended to increase the credit duration of their portfolios. This is relatively significant from a money market point of view but a part of investments in longer term maturities has been neutralised by higher liquidity pockets.”

Managers have also been looking elsewhere at  non-European corporate names which issue in euros. “The financial universe has been particularly impacted by numerous downgrades on banks and the ECB’s cash injection in the interbank market,” adds Mr Gandon.

“On the non-financial sector, we have seen a lack of interest for some corporates to issue short term papers. However, we have identified new opportunities on non-European corporate names issuing in euro and we have added new names in our eligible investment universe, especially US and few Japanese corporate issuers. On sovereigns, we have been investing in reverse repos  to increase the liquidity profile of our money market funds, all negotiated with highly rated counterparties, 24 hour call options and only highly rated government or government related debt used as collateral.”

Typically funds have extended their remits beyond from the ultra-cautious prime classification. Around 80 per cent of  money market funds at Amundi  are managed in the second more flexible money market category, says Patrick Simeon, the firm’s head of money market funds, up from 70 per cent in the past. It is very difficult to achieve performance in short dated and triple A rated funds as the guidelines are stricter, he says,  “possibly very restrictive considering present market conditions”.

The guidelines are much stricter in the first category to gain an AAA rating for funds, S&P requiring for example a minimum  of 50 per cent in A1+ short term rated issuances in the portfolio, says Mr Simeon. “When you see the level of return offered by these issues – for example short term paper issued by governments, supranational or agencies, is zero or even in negative territory for one day to one year tenures, it becomes more and more difficult to achieve a positive performance for such a fund.”

Mr Simeon has extended the Amundi fund’s duration to 200-250 days from 80-90 days to access a better credit premium.

“Since the financial crisis, the ECB has been providing lots of liquidity and has been putting in place unconventional measures, enabling a dramatic decrease of financial stress,” he adds, commenting on the heavy-handed regulation. “This makes the secondary money market more liquid and it is nowadays much easier to get liquidity when meeting redemptions.”

While money market funds are primarily used for corporate  cash management, there is currently also strong demand for these funds from investors looking to take risk off the table and use these vehicles to diversify their cash holdings away from a single deposit counterparty. Banks are also actively using them to help negate some of the regulatory burdens they face.

“We’ve seen assets under management in money market funds increase,” says Jim Fuell, European head of global liquidity at JP Morgan Asset Management. “Regulations like Basel III are changing banks’ approach to non-operational cash balances. Banks are looking at the liability side of their balance sheets and the run-off value assigned by new regulations to  various types of deposits. Certain types are at more risk of flight from a regulatory perspective and banks are obligated to hold greater levels of  capital against these.”

Mr Fuell points out short-term issuance is less valuable from a regulatory perspective, encouraging banks to issue longer-dated paper. “Some structured products give investors a two month put – which is attractive as it keeps the instrument no shorter than two months and pushes a more favourable tenor from a regulatory perspective,” he says. “Banks continue to be innovative in this respect.”

Banks often issue more units in their funds when they are looking for cash to meet their liquidity returns for the regulator  at the end of every quarter. “Some money market portfolio managers have managed their interest rate exposure more actively: in many occasions, variable rate investments – that is to say Eonia-based (Euro OverNight Index Average) investments – have enabled money market funds to benefit from seasonal peaks on Eonia fixings such as those registered around month/quarter ends when banks are looking for strengthening their liquidity ratios,” adds BNP’s Mr Gandon.

Banks are so keen to keep this business that they have been waiving  their fees. BNP  Paribas for example  has lowered fees, from 15 basis points to 8 basis points, to maintain its market position. “The institutions keep buying as they need these funds for capital preservation,” says Mr Gandon. “Eighty-five per cent of  our client base is corporate and institutions such as pension funds, and we are doing our best to help in this low interest rate environment. The Esma profile of money market funds means it still makes sense for institutions to invest in such products.”

Managers meanwhile face considerable uncertainty and risks surrounding the direction of European money market yields especially when considering the impending TLTROs (targeted longer-term refinancing operation), the first of which is due in mid September, and the second in mid December.

 “The first two TLTROs will be of maximum size of €400bn and are expected to be well received, with expected actual figure of Ä300bn,” says Joe McConnell, portfolio manager at JP Morgan Asset Management. “However, as 2011-12 is due to roll off – that is Ä350bn so LTROs should have a minimal impact on liquidity. But in future the effect of TLTROs could make money market rates even lower, so there are a lot of headwinds, and the future uncertainty is likely to keep rates at low levels.”

Floating rate notes using  three month Euribor with a one year maturity are popular. Agencies and other government related paper have become a more meaningful part of portfolios, as agencies in Germany and France are benefiting from relationships with a strong core sovereign.

Fund managers have also been looking to banks in emerging markets to improve returns and provide diversification, but the market was caught napping in August when South African money market funds lost money following a central bank-led bailout of African Bank Investments by the South African Reserve Bank, which imposed a 10 per cent ‘haircut’ on Abil’s senior debt. Most of the 15 funds with exposure to Abil have broken the buck. It is a reminder not to become too complacent. 

A way to diversify

A key benefit of investing in a money market fund is the diversification afforded by comparison to an investment with a single deposit counterparty, and the credit and risk management expertise professional asset managers wrap around these funds. However, in the wealth management segment, the low rates on offer are a deterrent.

“Overall we have a very low allocation to cash because cash yields are low and well below inflation,” says Willem Sels, UK head of investment strategy at HSBC Private Bank. “If inflation starts to rise as a result of a stronger economy, investors may start to anticipate higher interest rates.”

He cites floating rate notes (FRNs)as an opportunity for investors who take this view and want to keep some money in fixed income instruments to diversify against their equity holdings. Clients with Libor-linked mortgages can also benefit from having some investments which are Libor-based.

However, markets may be overestimating the speed of interest rate hikes, adds Mr Sels, and investors may therefore want to look at FRNs in the form of structured products. These are attractive for investors who believe that too many rate rises have been factored in, for instance some pay a guaranteed 2.1 per cent, but penalise the investor if Libor rates exceed 4 per cent, he says.

“We think Libor will be low for a long time with rises likely to start around March. It will take a while to get to 2.1 per cent and in the meantime these notes will be paying 2.1 per cent, so for a relatively conservative investor it is a good place to park cash. We like FRNs because a lot of investors want to limit the duration of the portfolio and we are working with clients to gradually reduce interest rate risk. These FRN coupons are reset every three months.”

VIEW FROM MORNINGSTAR: Times may be tough but these funds will always be relevant

Money market funds are certainly not a hot spot in today’s low interest-rate environment. The ECB’s recent announcement that it will cut rates to 0.05 per cent and the upcoming asset purchasing programme mean they are likely to remain low for some time.

Hence, the poor returns we have seen in money market funds are not likely to substantially improve any time soon. Indeed, the EUR Money Market and EUR Money Market – Short Term Morningstar categories have delivered poor annualised returns of 0.69 per cent and 0.29 per cent (in euro terms) over the last five years, respectively.

Investors have fled from this asset class in recent years, and even though the amount of money invested in these funds is still significant in Europe, with some €900bn, their market share has gradually reduced while allocation, equity, and even alternative funds have gathered the most attention.

But market cycles come and go and this environment will not last forever. Regardless, money market funds will always play a relevant role in European investors’ portfolios. This may be a very defensive role in a broader portfolio, or as a temporary investment while investors move from one asset class to another. Money market funds denominated in foreign currencies can also be an efficient way to take currency risk while minimising market and credit risk.

So what should investors be looking for when selecting a money market fund? In an investment class where value-added is very difficult to generate, and hence management teams and investment processes play a less relevant role in the outcome, fees are of critical importance, since they can eat a substantial chunk of pre-fees returns.

Although this is quite intuitive, at Morningstar we have observed that sometimes European investors do not pay as much attention to fees as they should. The chart above shows how important fees are in determining returns on this asset class. We clearly see that money market funds with high fees tend to underperform their lower cost competitors.

Thus, investors should put a lot of emphasis on fees when selecting money market funds  – and any fund actually – because, in today’s environment “every dollar counts”.

Javier Saenz De Cenzano, CFA, director of manager research Morningstar Iberia and Italy