Significant changes are about to occur this October in the mundane business of cash management. Cash management, you say, what’s that! Interest rates are zero or thereabouts, right? Well, yes, but several developments are having an impact on short term yields of some investment vehicles.
First of all, the Fed did actually raise rates by 25 basis points in December, so this is becoming a more interesting topic. At that time, we saw LIBOR rise from 30 basis points to approximately 60 basis points. Some or all of the rise in rates may have been absorbed by fees, which the money funds had suppressed during the zero interest rate period. So you may not have seen your returns increase by much, especially if you owned a “retail” money market fund as opposed to a “prime” institutional money market fund, which generally has higher minimums and takes greater risk than “retail” money funds. More on these riskier funds in a moment.
This is where the second and more critical development comes into play. Back during the financial crisis of 2008, the Reserve Fund, the nation’s oldest money market fund, was unable to pay investors back the principal portion of their investment. In other words, they “broke the buck”. While this is an extremely rare occurrence, the Reserve Fund does not hold the distinction of being the first to break the buck. In fact they were the second and for extra credit, dear reader, see if you can identify the first, circa 1994 in Milwaukee.
How did this happen? The value of the securities held in the Reserve Fund portfolio declined by approximately 3%, and it became clear that the firm would have to lower the net asset value of the fund to below par, which resulted in a run on the fund and its ultimate demise. While this shook the confidence of investors everywhere, there was some solace in the fact that the Reserve Fund only broke the buck because it lacked a large deep pocketed parent who could bail them out. In fact, a New York Federal Reserve Bank study published in 2012 revealed that 28 other money market mutual funds had fallen below the buck by an average of 2.2% during September and October of 2008, only to be voluntarily supported by large corporate parents.
While it was good for the investors in those 28 other funds to be bailed out, it was not good for US taxpayers who ultimately had to bail out a number of our large, swash-buckling financial institutions for reasons that went far beyond, but were not unrelated to, the problems in the money markets.
As a result, the SEC has adopted new rules for money market funds, effective October 14, 2016. In short, the new rules require institutional or prime money funds to move from a stable $1.00 price per share to a floating net asset value that would reflect the daily market value of the underlying portfolio. Retail money funds, owned by natural persons identified by a social security number, would continue to have the ability to use amortized cost as market value in order to preserve the mandate of stable value. Finally, “government” money funds would also be able to maintain a stable value mandate as long they invest 99.5% of assets in cash, government securities and repurchase agreements that are collateralized in government securities.
There are other changes for all money market funds. They would have the ability to charge redemption fees if the “weekly liquid assets” of a fund fall below 30% of total assets and would be required to charge redemption fees if “weekly liquid assets” falls below 10% of total assets. Furthermore, under certain conditions all money market funds could also suspend redemptions for up to 10 days.
What does this mean for cash management?
If you are invested in retail or Government money funds (i.e. the funds that will continue to “offer” the stable value of $1) you will continue to enjoy the liquidity of current money market funds, but at a lower yield.
Why the lower yield?
It is anticipated that most investors who are currently invested in prime money funds (soon to have floating market values) will opt out of these funds and reinvest in retail or Government funds with a fixed $1.00 value. In fact, many banks and brokerage firms are steering clients towards the stable value funds as a default option for cash sweeps. The heavy inflows into these funds will help keep yields a bit lower than the might otherwise have been.
Why have prime money market yields been going up?
Banks and brokers have been working on this transition for some time now and have already steered many clients out of the prime money funds, which has caused upward pressure on yields of non-government money market securities as these money funds are forced to liquidate. This supply/demand imbalance has created interesting opportunities for cash managers.
What should you do?
Perhaps it is time to think about creating several buckets for your cash holdings, in order to participate in what appears to be a slowly rising interest rate trend. Think of the differences in liquidity between the various alternatives and allocate portions of your total cash to stable value funds, prime money funds, ultra-short bond funds and even short-term or low duration bond funds. The advent of these new money market regulations compels all organizations and entities with large cash balances to take a fresh look at cash management. Large organizations with significant cash have been managing cash to their real liquidity needs for a long time. Perhaps it’s time for you to do that as well.