Since the global financial crisis, the notion of what constitutes an appropriate liquidity management and capital preservation strategy has become a source of heated debate among professional institutional investors and retail-oriented allocators alike, with varying opinions on how to balance a preference for returns against the need for immediate liquidity and capital preservation. And in an environment where yields remain hard to come by in the short end of the yield curve, we think a critical question is whether investors are once again becoming too complacent about risk in their short-term investments.
Money market reforms change the landscape
Last October’s well-publicized SEC reforms to regulated 2a-7 money market funds in the U.S. sought to address risks that came to light during the financial crisis with the demise of The Reserve Primary Fund, which infamously “broke the buck” in September 2008. In the aftermath of these reforms, more than $1 trillion of assets flowed out of prime (credit) money market funds and into “safer” (but lower-yielding) government-only money funds.
The mandated shift to a floating net asset value (NAV) calculation and the potential for fund administrators to impose “gates” or liquidity fees during times of stress placed the burden of risk squarely on the shoulders of prime fund investors, rather than the fund companies. In short, if investors wanted to earn the additional income that prime money market funds offered versus government-only funds, they had to assume the additional credit risk that came with it. “Caveat emptor” should now clearly be the credo of prime fund investors.
Prime funds stage an unlikely comeback
One might have expected these hefty changes to quash any hope for prime funds to regain a foothold as a viable liquidity management strategy. And that appeared to be the case for the fourth quarter of 2016, with prime fund assets bottoming at roughly $373 billion in November. But since then PIMCO and others, including the Wall Street Journal in a 10 July blog post, have noted a renewal of interest, with more than $42 billion flowing back into prime funds since January. While the current $415 billion in prime fund assets pales in comparison to the staggering $2 trillion back in 2008, this emerging appetite for what we view as mispriced risk is worth highlighting.
The shift seems to indicate that investors are being lured by the rise in prime market fund yields even though there may be better opportunities elsewhere. Returns and net yields for institutional prime funds (after fees) still underperform one-month Libor, a short-dated benchmark for credit risk that serves as a proxy for what these funds could be earning by investing in credit-related financial assets maturing within 30 days (the average fund’s weighted average maturity is around 22 days currently, based on Crane’s category data). Moreover, after fees they underperform the Federal Reserve’s benchmark for “credit-risk-free” liquidity: The Fed’s reverse repo facility currently pays 1.00%, compared with a current average prime fund yield of only 0.92%. This means prime fund investors are essentially lending their money to banks at rates below what banks would lend to each other.
Outsize risk for insufficient reward
Why should investors take on such mispriced credit risk? We can only account for it as arising from a misunderstanding of or complacency about the relative risks and liquidity of these investments. As professional investors, this seems like a short-sighted approach to us.
We think it’s important for investors not to take liquidity for granted by underappreciating structural or credit risk or the potential for illiquidity in prime funds during occasional periods of systemic stress. While we’re not sounding an alarm that a marketwide underappreciation of the “magic” of risk/maturity transformation may usher in the next shadow banking crisis, we think autopilot liquidity management that seeks yield without proper compensation for liquidity or credit risk could lead to investor regret down the road.
U.S. readers: For more ideas on capital preservation and liquidity management, please visit our hub for long-term thinking about short-term strategies.
Jerome Schneider is PIMCO’s head of short-term portfolio management and is a regular contributor to the PIMCO Blog.