Institutional Liquidity Managers and the New Reality

Transcription

1 Institutional Liquidity Managers and the New Reality The practical implications of money market mutual fund reform Tim Huyck Chief Investment Officer, Money Markets Michael Morin, CFA l Director of Institutional Portfolio Management Kerry Pope, CFA l Institutional Portfolio Manager KEY TAKEAWAYS Recent regulatory changes are creating a historic transformation of the money market mutual fund landscape. Government money market mutual funds are exempt from structural reform under the new rules; however, institutional prime (general purpose) and institutional municipal money market mutual funds will be subject to structural changes. Effective cash segmentation, specifically separating operating cash from cash with longerterm strategic utility, may help managers optimize liquidity, accessibility, and return potential. Liquidity managers should identify and evaluate risk-reward relationships for both operating cash and strategic cash to determine whether they are adequately compensated for the risk they are undertaking. There is no one size fits all solution for institutional liquidity management; solutions are customized based on thoughtful analysis, individual operating needs, and individual investment risk tolerance. Traditionally, institutional liquidity managers have turned to money market mutual funds (MMFs) for net asset value (NAV) stability, daily liquidity, yield, and safety. Today, however, a dynamic regulatory environment has altered the money market mutual fund landscape. This paper will discuss the practical implications of money market regulatory changes for institutional liquidity managers. While we recognize the importance of Basel III, the paper s primary focus will be on Money Market Regulatory Reform and how the new regulations are affecting traditional institutional liquidity managers. The paper also will review the ways in which cash segmentation may help liquidity managers more effectively optimize institutional liquidity, accessibility, and return potential. New regulations transform the money market Regulatory changes intended to strengthen the financial system after the 2008 financial crisis have created widespread modifications in the money market mutual fund landscape. Directed both at banks and at MMFs, the new rules are impacting supply-and-demand market dynamics, as well as the structure of traditional cash management investments. The MMF reform regulatory changes in particular will likely affect the way institutional liquidity managers view and manage their investment portfolios. At the bank level, Basel III has been directed globally at banking institutions whose large size, interconnectedness, and funding models are perceived by regulators to pose a

2 risk to economies and the financial system. Two important effects of this mandate have been to reduce the supply of short-term money market instruments issued by banks and to strengthen bank demand for U.S. government securities. A third effect is that Basel III has made holding certain institutional deposits unattractive for these banks. In contrast, money market mutual fund regulatory reform is intended to increase fund shareholder protection, particularly during periods of market stress. The rules create both definitional and structural changes. Government MMFs will be exempt from structural changes; however, institutional prime and institutional municipal MMFs will experience modifications in their structure. The new rules were approved by the U.S. Securities and Exchange Commission (SEC) in July 2014 and are required to be implemented by October A summary of these changes is provided in the grid in Exhibit 1. Government MMFs: No structural changes Exemption from structural reform will allow government MMFs to offer the same operational and investment utility they have had in the past, as these funds will continue to offer a stable $1.00 NAV, and not be subject to the potential of liquidity fees or redemption gates. However, the changes that will occur in prime MMFs, as well as shifts in money market supply and demand dynamics, may cause a change in the yield relationship between government and prime MMFs. Historically, government MMF yields have modestly trailed those of prime MMFs. Over the past 20 years, the yield differential or spread between prime MMFs and government MMFs has been minimal. Our analysis of prime and government MMFs during the 20-year period ending December 2014 revealed an average spread of approximately six basis points between the two fund types for much of that time frame, except for the two years Exhibit 1 Overview of Final Money Market Mutual Fund Rules Fund Type Net Asset Value (NAV) Liquidity Fee Redemption Gate U.S. Treasury Stable No No Government Stable No No Retail Municipal/Tax-Exempt Stable Yes Yes Retail Prime/General Purpose Stable Yes Yes Institutional Municipal/Tax-Exempt Floating Yes Yes Institutional Prime/General Purpose Floating Yes Yes Money Market Mutual Fund Reform Final Rule Implementation Date Floating NAV Applicable funds will price and transact at a net asset value per share that can change, or float, based on pricing the underlying fund holdings out to four decimal places ($1.0000) October 14, 2016 Liquidity Fee Redemption Gate Retail Fund Definition If a fund s weekly liquid assets were to fall below 30%, fund s board may impose a 2% fee on redemptions If a fund s weekly liquid assets were to fall below 10%, redemptions will be subject to a 1% fee, unless fund s board determines otherwise If a fund s weekly liquid assets were to fall below 30%, fund s board may suspend redemptions for up to 10 days Retail funds limit shareholders to beneficial ownership by natural persons (individuals) Institutional funds are open to any shareholders, including individuals, small businesses, and large corporations October 14, 2016 October 14, 2016 October 14, 2016 Source: Fidelity Investments 2

3 INSTITUTIONAL LIQUIDITY MANAGERS AND THE NEW REALITY spanning the financial crisis. 1 The yield differential between the two investments has the potential to grow in the new regulatory environment, though, as strong investor demand for U.S. Treasury and government securities with short maturities impacts the yield potential of government MMFs. Additional information on government MMFs as cashmanagement vehicles can be found in Leadership Series article Government Money Market Mutual Funds: An Attractive Option for Investors Seeking Capital Preservation and Liquidity (Mar. 2015). Institutional prime and institutional municipal MMFs: Structural changes imposed As mentioned above, the new rules governing MMFs will impose substantial structural changes on institutional prime and institutional municipal MMFs. The daily share prices of institutional funds 2 will float, under the new rules that is, the funds will be required to price and transact their shares out to four decimal places ($1.0000). Additionally, if the fund s weekly liquid assets as defined by the SEC fall below 30%, all prime and municipal MMFs may be subject to redemption restrictions in the form of liquidity fees and redemption gates. The new reality Floating NAV The four-decimal-place precision for pricing by institutional prime and institutional municipal MMFs is a process known as basis point rounding. Basis point rounding will cause shareholders to experience gains or losses if the per-share value of the fund changes by 1/100th of a penny. For more information on MMFs and floating NAVs, see Leadership Series article Money Market Reform Communication Series: Comparing Stable and Floating Net Asset Value Money Market Mutual Funds (Aug. 2014). An MMF s NAV can be affected by interest rate risk, changes in credit risk premiums, and idiosyncratic risk. Historically, price movements have been minimal under normal market 1 In this analysis, we define the financial crisis as the two-year period ending Jul. 31, Under the new rules governing money market mutual funds, prime and municipal money market mutual funds are required to be classified as either retail or institutional funds. Retail funds are defined as those that have policies and procedures reasonably designed to limit all beneficial owners to natural persons, meaning individual investors. Institutional funds consist of all funds that do not qualify as retail funds. conditions or when anticipated events such as news regarding interest rate hikes have fallen within market participants expectations. We expect that to continue to be the case under normal market conditions after the new rules take effect; however, we also believe that movements in the NAV could be fairly frequent. In contrast, historically, stressed market conditions have caused overall market liquidity to deteriorate, resulting in wider fluctuations in securities prices, which may cause some NAV fluctuations that are meaningful. Understanding the value of a basis point We believe it is important for liquidity managers to understand the value of a basis point in terms of the potential downside risk of the variable NAV, as well as the upside of the potentially higher returns that prime MMFs are expected to generate versus government MMFs. Changes in credit risk premiums credit spreads and idiosyncratic issuer risk have the potential to negatively affect an MMF NAV. The idiosyncratic credit risk experienced by a single issuer held in a variable NAV MMF could prompt a price decline that is enough to cause the four-decimal-place NAV to decrease. For example, a 1% price drop (from 100 to 99) in a security that comprises 2% of total assets would cause the MMF s NAV to fall by 2 basis points to $0.9998, assuming a $1.00 initial NAV. Of course, credit risk in a prime or municipal MMF may not be limited to a single issuer and could be impacted by a widening of credit spreads across a specific sector or more broadly across all credit, as was the case in If this type of event were to occur in the future, it is likely to have a more negative impact on a fund s NAV than the single idiosyncratic credit event depicted above. The value of a basis point must also be understood in the context of potentially higher yields that prime MMFs are expected to deliver versus government MMFs. If the yield differential between the two funds were 10 basis points and the investor held $100 million in the fund for a full year, the investor would earn an incremental $100,000 in interest income. We therefore believe that institutional investors in prime or municipal MMFs will need to think differently about MMF investing. In the hypothetical examples we have presented above, an institutional prime MMF investor with a $100 3

4 million investment at an initial purchase price of $ who redeems at $ would incur a $20,000 loss. However, if the investment were held for an entire year and the yield differential between prime and government MMFs were 10 basis points, the investor would have earned an incremental $100,000 in interest income by choosing the prime MMF. The total return for this hypothetical investment would be $80,000. Exhibit 2 summarizes the value of a basis point, assuming a hypothetical $100 million investment. Regulators simplify tax and accounting matters for floating NAV funds The potential to generate gains and losses from changes in a floating MMF NAV caused shareholder concerns about creating taxable events, a situation that can exist under current law. The regulators allayed many of these concerns, however, by simplifying several important tax and accounting matters related to floating NAV MMFs: The U.S. Department of the Treasury and the Internal Revenue Service issued guidance stating that shareholders of floating NAV MMFs will be able to report a single net number for the gains and losses experienced over the course of a year, rather than reporting individual transactions. Their guidance was also clear that floating NAV MMFs will not be subject to the wash sale rule. 3 3 A wash sale occurs when a security is sold at a loss and within 30 days prior to or after that sale, a substantially identical stock/security, or a contract/option is purchased by the same individual, the individual s spouse, or a company controlled by the individual. Exhibit 2 Value of a Basis Point Under a Floating Rate NAV (Assumes a $100 million investment) Investors may want to think differently when trying to decide between investing in a prime MMF or government MMF. Increase/Decrease Increase/ Decrease 1 Basis Point $10, Basis Points $100, Basis Points $250,000 Source: Fidelity Investments. The SEC stated that a floating NAV MMF can be considered a cash equivalent under the new regulations. Redemption restrictions As part of the 2014 regulatory changes, the SEC gave mutual fund boards the ability to impose liquidity fees and redemption gates on prime and municipal MMFs. Liquidity fees If a fund were to fall below 30% weekly liquid assets, a fund s board may impose a liquidity fee of up to 2% on shareholder redemptions. The fee is payable to the fund. The board has the discretion to impose a lower fee or to take no action. To impose a fee, the board must find that a fee is in the fund s best interests. If weekly liquid assets fall below 10%, the board must impose a 1% liquidity fee, unless the board determines that a fee is not in the fund s best interests. In both circumstances, the fee would be lifted when weekly liquid assets return to 30% or when the fund s board determines that a liquidity fee is no longer in the best interests of the fund. Additionally, a fund must disclose promptly and publicly whether a liquidity fee has been imposed or removed, as well as a discussion of the board s analysis in determining to impose or remove a fee. Redemption gates A fund s board also may impose a redemption gate ( a gate ), halting all shareholder redemptions for up to 10 consecutive days, if weekly liquid assets fall below 30%. Like the imposition of a fee, the board must determine that the gate is in the fund s best interests. The gate would be lifted when weekly liquid assets return to 30% or when the fund s board determines that a gate is no longer in the best interests of the fund. The gate cannot be in effect for more than a total of 10 days within a 90-day period. As with a liquidity fee, an MMF must disclose promptly and publicly whether a redemption gate has been imposed or removed, in addition to a discussion of the board s analysis in determining whether to impose or remove a gate. For further information regarding redemption restrictions for MMFs, see Leadership Series articles Money Market Reform Communication Series: Redemption Restrictions for Money Market Mutual Funds: Liquidity Fees and Redemption Gates (Aug. 2014) and Understanding Liquidity in Money Market Mutual Funds (Aug. 2014). 4

5 INSTITUTIONAL LIQUIDITY MANAGERS AND THE NEW REALITY Navigating the new environment Taking a cash segmentation approach Institutional liquidity managers may find that segmenting cash separating cash with different purposes into individual buckets may help them navigate the new environment more effectively, and strike an optimal balance between maximizing both liquidity and potential returns. The varied purposes of institutional cash make its segmentation based on objectives and time frames a logical solution for liquidity managers. Short-term operational cash can be distinguished from longer-term cash whose objective is more strategic and investment oriented. Operational cash would be invested for accessibility and liquidity, while strategic cash could be focused more on return generation. From a practical standpoint, liquidity managers would need to identify the specific purposes that operational cash would serve. Operational cash Government MMFs and demand deposit accounts may be compelling choices for operational cash because of the immediate accessibility and principal stability of these investments. Prime MMFs also may be options for operational cash, in that prime MMFs will continue to be treated as cash equivalents, offer a high degree of accessibility and liquidity relative to longer-term alternatives, and, in the future, may offer a higher yield differential to government MMFs than they have historically provided. For more information on the historical yield differentials between government MMFs and prime MMFs, see Leadership Series article, Government Money Market Mutual Funds: An Attractive Option for Investors Seeking Capital Preservation and Liquidity (Mar. 2015). The different features of government MMFs and prime MMFs may impact liquidity managers decisions on allocating operational cash to a prime MMF. The liquidity manager should consider whether the yield differential is adequate to compensate for the prime fund s potential NAV movements and the possibility of fees and gates. Exhibit 3 compares the value proposition of a prime MMF, today, with the post-regulatory reform environment. After careful consideration, some managers may decide that they need the highest level of accessibility for their operational cash needs and invest in a government MMF or in demand deposit accounts, while others may determine they are adequately compensated for the trade-offs of a prime MMF. Exhibit 4 offers use-case examples to show some of the factors considered by institutional liquidity managers in making their cash allocations. Exhibit 3 Value proposition of a prime MMF, today, versus the post-regulatory reform environment Liquidity managers will need to consider changes in the operational and investment utility of their money market investments in the new regulatory environment. Current Operational Utility Future Operational Utility $1.00 NAV (Amortized Cost Valuation) Variable NAV to four decimal points No liquidity fees; the potential for a 7-calendar day payment delay Cash & cash equivalents Tax simplicity Same day settlement Late day Portal trading Diversified portfolio Professionally managed Market-based returns Potential liquidity fee of up to 2%; the potential for a 10-business day redemption gate Cash & cash equivalents Aggregate tax reporting permitted Uncertain Uncertain Portal trading Diversified portfolio Professionally managed Market-based returns with credit spreads likely wider Diversification does not ensure a profit or guarantee against a loss. Source: Fidelity Investments. 5

6 Strategic cash Investing strategic cash may offer liquidity managers an opportunity to generate higher returns, subject to higher risks. The longer-term focus of the strategic cash segment lets managers consider investment options with higher return potential, such as prime MMFs, ultra-short bond funds, short duration bond funds, and separately managed accounts (SMAs). Liquidity managers may already be familiar with many of these investments; however, a risk-reward analysis should be performed to include, among other considerations, recognition of NAV price fluctuations and, in the case of non MMF investments, less-favorable accounting treatment. Summary The new face of institutional liquidity management: customization that optimizes liquidity and returns Despite having what may seem to be a distant effective date of October 2016, the rule changes have already created a more complicated environment for many institutional liquidity managers. The days of one simple cash management solution have been replaced by the need for a customized Exhibit 4 Use-Case Examples: Liquidity Management Each situation is different institutional liquidity management is based on thoughtful analysis, individual operating needs, and individual investment risk tolerance. Current Investments Concerns/ Considerations Conclusions Actions/Client Decides To: Representative profiles of liquidity managers, their potential concerns, considerations, and decisions for a post-money market reform environment Client A $500 million portfolio $200 million deposited between two credit banks $300 million in several prime MMFs Will be in institutional prime MMFs with floating NAV Prime MMFs are subject to potential liquidity fees and redemption gates All $500 million is operating cash; none can be considered longer-term strategic cash Principal need is ongoing accessibility and liquidity Keep bank accounts Move a portion of money from prime MMFs to government MMFs Client B $1 billion portfolio $500 million deposited between two credit banks $500 million in multiple prime MMFs Will be in institutional prime MMFs with floating NAV Prime MMFs are subject to potential liquidity fees and redemption gates Banks limit client s deposits because of Basel III rules Believes liquidity fees and redemption gates are unlikely Believes that credit spreads will widen enough to compensate for risk of potential liquidity fees and redemption gates Keep a portion of money in current bank solutions Move a portion of money from prime MMFs to government MMFs Consider some money to be strategic cash and keep in prime MMF Client C $5 billion portfolio $2 billion deposited between two credit banks $2 billion in multiple prime MMFs $1 billion in ultra-short bond fund and SMA Will be in institutional prime MMFs with floating NAV Prime MMFs are subject to potential liquidity fees and redemption gates Banks limit client s deposits because of Basel III rules Client is concerned about rising interest rates over next few years Client is somewhat concerned about value of basis point(s) deterioration in his NAV Not comfortable with risk of potential liquidity fees and redemption gates Optimizes liquidity and return by investing in various investment vehicles Move a portion of money out of prime MMFs into government MMFs Invest remainder across suite of investment solutions: prime MMFs and various non 2a-7 products, including ultra-short bond funds and SMAs For illustrative purposes only. Source: Fidelity Investments 6

7 INSTITUTIONAL LIQUIDITY MANAGERS AND THE NEW REALITY suite of products, based on liquidity needs, strategic goals, and risk tolerance. Institutional liquidity managers would now be well served to begin reviewing the details behind the purpose of their assets and the amount needed to meet each function. Shorterterm operational cash may require one set of investment solutions, while taking an updated view of longer-term strategic cash may open up a set of investment opportunities that had not been considered. Managers also will need to determine their risk tolerance level and may want to approach liquidity management based on their anticipated total rate of return when deciding between MMFs, judging whether the anticipated yield spread between prime and municipal MMFs versus government MMFs will compensate them for potential trade-offs and risks. The new environment may be more challenging initially; however, as is often the case, transitions may lead to new opportunity. Customizing cash solutions may provide the chance to better optimize liquidity and returns and once liquidity managers identify the operational and strategic utility that best fits their institutions, they will find a wide variety of investment solutions available to help accomplish their goals. AUTHORS Tim Huyck Chief Investment Officer, Money Markets Tim Huyck is chief investment officer of the Money Market Group in the Fixed Income division at Fidelity Management & Research Company. In this role, he works with the money market investment team to determine investment strategy and risk management practices for Fidelity s money market mutual funds. Michael Morin, CFA l Director of Institutional Portfolio Management Michael Morin is director of money market institutional portfolio management in the Fixed Income division at Fidelity Management & Research Company. In this role, he is responsible for communicating portfolio strategy and positioning, designing customized liquidity management solutions for institutional clients, and providing portfolio reviews. Kerry Pope, CFA l Institutional Portfolio Manager Kerry Pope is an institutional portfolio manager in the Fixed Income division at Fidelity Management & Research Company. In this role, he is responsible for communicating portfolio strategy and positioning, designing customized liquidity management solutions for institutional clients, and providing portfolio reviews. Fidelity Thought Leadership Vice President and Senior Investment Writer Maggie Stenman provided editorial direction. 7

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