New U.S. money market fund rules have been both an albatross for money market investors and a beacon for ultrashort bond funds since they were announced by the SEC two years ago. With less than 90 days until the new rules go into effect on 14 October, the landscape at the front end of the yield curve is finally changing, creating potential opportunities for short-term investors.
The most noticeable effect of the upcoming reform is that assets in institutional prime money market funds, which invest in credit securities, have declined dramatically. Since last October, such assets have decreased by $310 billion (a drop of about 32%), with about 40% of that occurring during the last two months, according to data from the Investment Company Institute. Another $200 billion will likely be withdrawn by the time money market reform takes effect in October, based on industry estimates, leaving prime funds a mere 45% of their post-crisis peak size in 2013.
For investors in short-term markets, monitoring outflows from prime money market funds is essential because the funds have traditionally been among the largest buyers of bank commercial paper (CP) and certificates of deposit (CDs). Prime funds are now buying fewer of these securities as their assets shrink and they shorten their maturity profiles in anticipation of further withdrawals over the next two to three months.
Banks in search of new funding sources
Most large financial institutions have relied on prime funds for cheap wholesale funding since 1971. So the dwindling demand from prime funds is putting upward pressure on bank CP and CD rates. This is most easily observed through the move higher in Libor (the London Interbank Offered Rate), which has increased by more than 16 basis points over the past month. While 0.16% may not seem like much, trillions of dollars of global derivatives, mortgages and bond contracts are tied to the Libor rate, and so higher levels have ramifications across markets.
Banks will now need to find new sources of funding. Some that have relied heavily on wholesale funding will turn to official sources. The Bank of Japan, for example, recently doubled the size of its U.S. dollar funding facility for Japanese banks to ease some pressure from the diminished demand for Japanese bank CP and CDs. Other banks are simply continuing to re-price their CDs at higher rates to draw new entrants into the fold.
It is our view that the upward pressure on Libor will continue into October when money market reform officially takes effect. While in the past, a rise in Libor typically indicated declining perceptions of bank creditworthiness, the current move is merely a re-pricing of risk during a handoff in front-end wholesale funding markets from prime funds to a potential new investor base.
Cash investors may therefore want to consider taking advantage of this shift higher in Libor by investing in short-term and ultrashort bond funds that invest in assets tied to Libor rates, such as floating rate notes, term CP and CDs, and foreign securities that when hedged earn premiums to U.S. Libor. With three-month Libor now yielding more than two-year U.S. Treasuries, many of these short-dated assets and the vehicles that invest in them are out-yielding longer-duration bond index funds and represent an opportunity for investors with excess cash during this changing of the guard.