Money markets have a $750 billion problem
A $750 billion industry still struggling to recover from the latest crisis is cracking under the Federal Reserve’s “low for longer” mantra on US interest rates.
Prime money market funds – a longtime favorite for anyone looking for a cash-like investment with a little extra yield – face an existential challenge, just four years after a regulatory overhaul aimed at restoring confidence following the global financial crisis. Earlier this year, assets in such vehicles fell 20% in just six weeks, sparking talk of further reforms. But some industry leaders are opting for another solution: shutting them down.
Vanguard Group, the world’s second-largest asset manager, is switching a $125 billion fund to buy government debt rather than the short-term corporate bonds it has invested in for decades, and Northern Trust Corp. and Fidelity Investments recently phased out funds with a similar focus altogether. The decisions entrench a prolonged decline in blue-chip funds and could hurt a market that thousands of companies rely on for funding.
These strategies are collateral damage of the Fed’s aggressive approach to rate suppression for years to come. The realization that these funds, which are supposed to offer an advantage over more conservative alternatives, will not become much more attractive any time soon is a grim prospect for investors who often have to endure limits on redemptions – known as “doors” – to buy them. Asset managers, meanwhile, are finding their fees increasingly difficult to justify.
“We’re looking at a very long period at the zero lower bound – that’s brutal for money market funds,” said Jon Hill, rates strategist at BMO Capital Markets. “What’s the argument for getting into a blue chip fund, which could be closed and which is less liquid than being in Treasuries and repos, if you only want to gain a few basis points on yield ?”
Funding crunch reminiscent of 2008
As the pandemic crushed economic activity and ravaged global markets in March, blue chip fund investors moved money as fast as they could into government money market funds – seen as the safest havens as they are limited to short-term government securities and related secured lending markets. Prime funds lost more than $150 billion in assets due to withdrawals between late February and early April; as a cash-like product with credit exposure, these funds are particularly vulnerable to runs in a crisis.
This has led to a paralysis of the market for so-called commercial papers – IOUs issued by companies to meet short-term financing needs, such as payrolls – as the prime funds that typically purchase this debt have become sellers. The ripple effects contributed to a spike in LIBOR, a benchmark rate for interbank lending that underpins trillions of dollars in business and consumer loans, prompting the Fed to take emergency action.
To some, it was all chillingly reminiscent of the September 2008 cataclysm, when an investment in Lehman Brothers paper caused a blue-chip fund’s share price to plummet below $1 and ‘break the ball’. . This event sparked runs on money market funds then managing about $3.5 trillion, spilled into volatility in global markets, and spurred sweeping reforms.
The rules, which came into effect in 2016, included a separation of retail and institutional investments, the introduction of barriers to prevent mass redemptions and the abolition of the traditional $1 stable price for shares in favor of a floating net asset value (NAV). While the latest turmoil for money market funds has lagged well behind the chaos of 2008, the resurgence of fears around redemptions suggests another overhaul is likely.
“We expect another round of regulatory reform,” said Greg Fayvilevich, senior director at Fitch Ratings. He expects regulators to focus on the functionality of liquidity fees and gates, as “sensitivity around this liquidity threshold has made runs on money market funds more likely.” The additional costs associated with another possible round of rule changes could be among the factors leading to more fund closures, he said.
Several fund managers, including T. Rowe Price Group Inc. and Federated Hermes Inc., have already waived the fees they typically charge prime fund investors in an effort to preserve client revenue, and additional costs would make the business even less attractive.
BlackRock Inc. wants to create a new platform for trading commercial paper (CP) to strengthen the liquidity of these holdings. That would leave blue-chip funds less dependent on fickle secondary markets and potentially strained dealer balance sheets, according to Deborah Cunningham, chief investment officer for global liquidity markets at Federated Hermes in Pittsburgh.
Federated is among those still committed to blue chip funds, which have recouped some of the institutional assets lost in the March carnage, though many retail investors remain on the sidelines. “People continue to want choice, so I think they’re going to demand there is choice,” Cunningham said.
Still, blue chip funds are likely to be a pick-and-choose rather than a default investment in years to come. Fewer funds could ultimately reduce demand for CP and push rates higher, but yields are currently only a fraction of what they were before the Fed cut its key rate target to near zero. Retail funds fell for a 10th consecutive week in the period ending September 2, capping the longest period of outflows since 2016.
According to Joe Lynagh of T. Rowe, who manages the money market and short-term debt fund.
“There’s always a reason to hold cash: you have to pay your bill next month and you really should hold it in cash,” he says. “They can invest further along the curve, lower rate credits, things money market funds can’t invest in.”
—With the help of Annie Massa.