Asset Management

The Changing Face of Money Market Funds

Michael Ferraro, CFA, Money Market Fund Portfolio Manager and Director of Global Public Markets

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The appeal of money market funds has been well known to investors for decades—you put a dollar in and you get it out, you can have it when you need it and you may get a decent yield versus other similar options, such as bank products. The deal remains largely the same today, but without the yield component, which has been missing in action, a casualty of the current rock-bottom interest rate environment. Below the surface, however, much has changed in the money market fund landscape over the last several years, and more could be in store as reform proposals currently under consideration could fundamentally remake the asset class as soon as this year. One such proposal calls for removing the stable $1 net asset value (NAV) share price which has been the hallmark of money market funds since the first fund was launched in 1970. By “floating” the NAV, investors in registered money market mutual funds1 would be exposed to the daily ups and downs of markets and could realize losses in an asset class whose track record of preserving capital is hard to beat.

Article Highlights

  • Regulators are considering more changes to registered money market funds, including a proposal to eliminate the $1 stable share price.
  • Rule changes and market effects have caused money market funds to become more conservative since the subprime crisis in 2007.
  • Despite low yields and changing regulations, money market funds have continued to serve as an important liquidity vehicle for both retail and institutional investors.
  • Historically low yields will likely remain a factor for the next few years.

EXHIBIT 1: Short-term bond yields remain grounded (%)

Short-term bond yields remain grounded (%)

Source: Federal Reserve Board, Haver Analytics, as of March 2013

These latest proposals and the current debate in Washington may have significant consequences for institutional and retail investors. We believe investors should pay close attention to this debate in the coming months to better understand how the asset class may change in the coming months and years.

A Crisis, a Government Backstop and Regulatory Changes

Money market funds peaked at nearly $4 trillion in 2007 (see exhibit 2) and today still have over $2.6 trillion in total industry institutional and retail assets. The asset class has served as a cornerstone of investment strategies for all investors as they provide a liquid vehicle focused on capital preservation. Much has changed since 2007, however, with several events contributing to the current state of money market funds, including: the subprime crisis, shrinkage of the commercial paper and structured products market, the Lehman Brothers bankruptcy and a series of regulatory changes implemented in 2010.

EXHIBIT 2: Total money market fund net assets peaked in 2009

Total money market fund net assets peaked in 2009

Source: Investment Company Institute, as of January 2013

Money market funds began down this bumpy road when the subprime crisis first surfaced in 2007, causing problems at some large financial institutions. The funds have traditionally invested in U.S. dollar-denominated fixed-income instruments on the short end of the curve (which generally refers to yields that have a year or less to maturity) which may include Treasuries, bank debt, European dollar-denominated debt, structured products, such as asset-backed securities, and commercial paper. The markets for some of these securities, such as structured products and commercial paper, abruptly halted or significantly slowed in 2007, causing fund managers to increase holdings in Treasuries and U.S. government agency debt (such as bonds issued by Fannie Mae and Freddie Mac). Since then, many issuers have scaled back their short-term debt or have sought alternative financing, causing a significant drop in available commercial paper and structured products such as asset backed securities. There is approximately $1 trillion less available in commercial paper now than there was in 2007, for example.

The decline in available securities was one example of a behind-the-scenes problem for money market funds, which most investors likely didn’t notice. Then, in 2008, during the peak of the financial crisis, a $60 billion registered money market fund “broke the buck,” which meant the fund redeemed shares for less than $1. The event generated a lot of anxiety, even though the fund’s manager eventually returned 99 cents of each $1 invested to investors. This had only happened once before, in 1994, when another fund returned 96 cents to investors. The 2008 event spooked investors, causing the Federal Reserve to provide an insurance protection program that guaranteed the principal of all registered money market funds for a period, to quell the panic. These events raised questions about preventing future “runs” on money market funds and how to keep the government from protecting money market fund assets against losses in the event of future crises.

In March 2010 the Securities and Exchange Commission implemented several changes to 2a-7, the regulations that govern money market funds, placing further restrictions on the types of securities and the maturities of portfolios (see exhibit 3). The rule changes caused funds to become extremely conservative, leading us to today’s yields that are in the low single digit basis points (a basis point is equivalent to 0.01% or (1/100th of a percent). Just a year later, markets were challenged by two events: the European sovereign debt crisis and the U.S. debt ceiling debate and subsequent credit rating downgrade. Money market funds withstood that period of volatility without a single loss.

EXHIBIT 3: Many changes to money market funds since inception

Many Changes to Money Market Funds Since Inception

Source: Investment Company Institute

These changes, along with fewer investment options on the short end of the yield curve, have caused managers to invest significantly larger amounts of capital in more conservative Treasury and agency debt (see exhibit 4).

EXHIBIT 4: Commercial paper holdings in money market funds have fallen versus T-Bills since 2007

Commercial paper holdings in money market funds have fallen versus T-Bills since 2007

Source: Investment Company Institute, Haver Analytics, monthly data as of February 2013, portfolio holdings shown are for taxable money market funds.

The Current Debate in Washington

The Dodd-Frank Wall Street Reform and Consumer Protection Act established the Financial Stability Oversight Council (FSOC), which is mandated with “monitoring the stability” of the nation's financial system. FSOC is proposing to reform the money market fund industry to a greater degree than the 2010 reforms. FSOC has three proposals that it drafted and is considering, and they are currently with the SEC for review:

  • Floating NAV: Require money market funds to have a floating NAV per share by removing the special exemption that currently allows them to maintain a stable NAV. Under this scenario, the value of MMFs’ shares would not be fixed at $1.00.
  • Stable NAV with capital buffer and a holdback provision. This proposal would allow money market funds to keep a $1 NAV share price, but require them to hold up to 1% of assets as a “capital buffer” to absorb day-to-day fluctuations in the value of the funds’ portfolio. The NAV buffer would be paired with a requirement that 3% of a shareholder’s highest account value in excess of $100,000 during the previous 30 days — a minimum balance at risk (MBR) — be made available for redemption on a delayed basis. Most redemptions would not be affected by this.
  • Stable NAV with NAV buffer and other measures. This would allow money market funds to maintain a stable $1 share value but require them to keep a buffer of 3% to absorb losses should the share price falls below $1. This could be combined with other measures such as more stringent investment diversification requirements, increased minimum liquidity levels and more robust disclosure requirements.

The SEC is expected to begin weighing these proposals soon.

Many Possible Outcomes

It is unclear which proposals will be adopted, though each of them, as they currently stand, is worth monitoring. Some of the potential consequences, such as capital buffers, may have minimal impact on investors. Adoption of a market-driven NAV, however, could cause investors to re-evaluate their investment in money market funds, particularly for institutional investors whose primary reason for investing in them is capital preservation. About $1 trillion of money market fund assets are held by institutional investors, including the cash holdings of many large corporations. Corporate treasurers, who are responsible for overseeing corporate cash, are in many cases, unable to put their company’s capital at risk, which is what would happen in a floating-NAV scenario. A 2012 survey by the Association for Financial Professionals found that a floating NAV would cause many to discontinue investing in money market fund vehicles and some to reduce or fully liquidate their holdings.2 These were the findings from the survey:

  • 33% would stop investing and divest all their holdings if money market funds are subject to a floating NAV.
  • 23% would stop investing and reduce, but not eliminate holdings.
  • 23% said a floating NAV would have no bearing on their organization’s willingness to invest in money market funds.
  • 14% would monitor and sell funds if/when NAV falls below $1.
  • 7% would stop investing but maintain holdings.

Retail investors would also need to closely weigh the risk/reward relationship of owning shares in a liquid short-term strategy subject to the daily ups and downs of markets. Traditionally, one of the attractive features of money market funds for many retail investors has been the ability to write checks from an account. If an investor writes a check on a fund that has lost or gained value, the investor may have tax liabilities under current law.

Looking Ahead: Continued Low Rates and Uncertainty

With minimal yields, money market funds have become less of an investment vehicle and more of a liquidity instrument for most investors. Before 2007, investors could invest in a money fund, and expect to get a 2-4 percent return, with a very small chance of losing principal. Investors expected to get all of their money back and a little extra, though there were no guarantees. Interest rates are expected to remain low this year and next, as the Federal Reserve has said it will continue to maintain a low interest-rate policy as long as unemployment remains above 6.5 percent and inflation stays below 2.5 percent. While changing the rules and regulations of money market funds has limited the pool of investment opportunities for money market funds, the interest rate environment has taken the largest toll on returns in the asset class. Under current conditions and market expectations interest rates will remain low for at least the next two years.

Because a range of outcomes is possible, we at TIAA-CREF will continue to maintain flexibility in our money market fund strategies to ensure that we are able to respond effectively to any regulatory and interest rate changes that may occur. We encourage all investors to assess their long-term asset allocation and diversification strategies if the historical risk/reward characteristics, tax treatment, or other factors related to money market funds fundamentally change.