Post money market reform: Considering trade-offs between short bond funds and institutional prime money market funds

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1 Post money market reform: Considering trade-offs between short bond funds and institutional prime money market funds September 13, 2016 Lucy Momjian, CFA Vanguard

2 Agenda Money market and reform overview Fixed Income review Historical Risk/ Return Analysis Forward looking analysis (VCMM ) Conclusion 2

3 Money Market vs. Bond Market Funds Money Markets Bond Markets Funding market often used for covering operating expenses, working capital, or other short-term liquidity needs Maturities are one year or less Instruments include commercial paper, certificates of deposit, repurchase agreements, T-bills and notes. $2.7 trillion in assets under management as of calendar year end 2015 * Funds are registered under the Investment Company Act of 1940 and regulated under rule 2a-7 of that act. - Establishes maturity limits and liquidity constraints Raise capital for long-term purposes, such as M&A, business expansion, or capital expenditures. Initial maturities are greater than 1 year. Instruments include treasury and agency, credit, asset backed, residential and commercial mortgage backed securities. Barclays Aggregate: $18.1 trillion market value as of calendar year end 2015 Bond funds are registered under the Investment Company Act of 1940, but not regulated under rule 2a-7 of that act. * Source: Morningstar Direct 3

4 Money market mutual funds asset growth 3,500 3,000 Assets Under Management ($ billion) 2,500 2,000 1,500 1, Institutional Non-Institutional Source: Morningstar AUM has grown at a 10.5% CAGR Institutional represents two-thirds of the assets 4

5 Money market funds directly affected by Global Financial crisis (GFC) Key Market Events September 2008: September 7: Government placed Fannie Mae and Freddie Mac in receivership September 15: Lehman Bros., lacking a buyer and failing to obtain government assistance, declared bankruptcy, triggering a credit freeze Week of September 15: Investors redeemed $300 billion from prime money market funds Weekend of September 13 and 14: Bank of America Corp. agrees to buy Merrill Lynch for $50 billion September 15: The $62 billion Reserve Primary Fund failed to maintain $1.00 NAV because of Lehman exposure Source: Investment Company Institute, Money Market Funds in 2012, February 14,

6 Money market reform summary Since the crisis, the Securities and Exchange Commission have made structural and operational reforms to limit the risk of investor runs on money market funds, while preserving the benefits of the funds. Amendments to rule 2a-7 in March 2010, further reducing interest rate, credit and liquidity risks. Money market reform package announced in July 2014, with significant portion of implementation to take place October 14, Distinction of Institutional and Retail investors and fund requirements Floating Net Asset Value (NAV) Institutional prime money market funds no longer able to use amortized cost accounting. Liquidity fees and redemption suspensions (gates) Enhanced disclosure requirements NAIC Securities Task Force decided to eliminate the Class 1 List, directly impacting non-government money market funds. 6

7 Comparing characteristics of money market funds, ultra-shortterm, and short-term bond funds Type Underlying investments Term/duration Accounting method Liquidity Money Market Funds (U.S. government and prime) Treasury bills and notes, U.S. governmentagency securities, repurchase agreements, and (prime only) commercial paper, certificates of deposit (CD s), time deposits, and municipal bonds. Maximum 60-day weighted average maturity U.S. government and retail prime: Amortized cost, which smooths price movements Institutional prime: market value (effective October 14, 2016) U.S. government: Can redeem shares any time. Institutional and retail prime: Potentially up to 2% redemption fees and 10-day redemption suspensions, if weekly liquid assets drop below 30% (according to SEC rulings effective October 14, 2016). Imposition of 1% liquidity fee if daily liquid assets fall below 10%, unless declined by fund board of directors. Ultra-short-term bond funds Treasury and agency securities, corporate bonds, asset-back securities, and residential and commercial mortgagebacked securities Average duration or average effective maturity of approximately 1 year. Market value Can redeem shares any time. Short-term bond funds May vary in accordance with mandate some funds may hold only government securities, while others include short-term corporate securities, asset backed securities, residential and commercial mortgage-backed securities Average duration of 2-3 years Market value Can redeem shares any time Notes: There may be other material differences between products that must be considered prior to investing. Source: Vanguard 7

8 Fixed Income Review 8

9 Term Premium is compensation for the uncertainty in how interest rates will evolve over time Two classic hypotheses for term structure of interest rates: Pure expectations hypothesis Liquidity (or risk) premium hypothesis Long-term yields are likely combination of both 2.5% 2.0% 1.5% Yield Spread 1.0% 0.5% 0.0% -0.5% -1.0% 2 year Treasury Bond / 3 month T-Bill yield spread Source: Bloomberg 9

10 Credit bonds are issued at a positive yield spread over comparable U.S. Treasury bonds 12% 10% 8% Yield 6% 4% 2% 0% U.S. ST Credit Index U.S. ST Treasury Index Notes: Studies have shown that yield spreads of credit bonds are larger than have been justified by subsequent default rates. Explanations for additional credit spread include liquidity costs and a general risk premium. See Ng and Phelps (2011) and Elton, Gruber, and Mann (2001). Source: Barclays 10

11 Bonds with negative convexity are offered at positive yields spreads over comparable U.S. Treasury bonds Bonds with negative convexity underperform in both rising and falling rate environments. Positive yield spreads are compensation for both prepayment risk and negative convexity. 12% Price 10% Positive Convexity (Treasury Bond) 8% Yield 6% 4% Negative Convexity (Mortgage Backed Security) 2% 0% Yield US Agency RMBS Index US Intermediate Treasury Index Source: Barclays 11

12 Historical risk/return analysis 12

13 Higher historical returns accompany wider return distributions 16.0% 12.0% 12.4% Percentiles key: Rolling 12 month total returns 8.0% 4.0% 0.0% 5.4% 5.6% 3.0% 3.6% 0.1% 0.4% 9.0% 5.5% 4.6% 0.7% 0.8% 95 th percentile 75 th percentile Median 25 th percentile 5 th percentile -4.0% Government Money Market Index Prime Money Market Index Ultra-short bond Index Short-term credit Index Notes: Chart represents hypothetical gross return distributions for Vanguard-created, customized indexes based on trailing 12- month gross returns from Barclays POINT for January 1992 through September The sector composition for the ultra-shortterm bond index was based on industry ultra-short-term bond-fund sector weights in the Morningstar database over the analysis period and the makeup of Vanguard Ultra-Short-Term Bond Fund. The U.S. government money market index combined U.S. Treasury and agency securities, while the prime money market index also included seasoned corporate bonds with 60-day weighted average maturities. Although the custom prime money market index matches the risk-factor sensitivities of a pure money market fund, seasoned corporate bonds used may have higher yields than commercial paper, which is a typical prime money market holding. This may upwardly bias historical prime money market return distributions presented. The short-term credit index was represented by the standard Barclays U.S. 1 5 Year Credit Bond Index. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index. Sources: Vanguard calculations, based on data from Barclays POINT. 13

14 Observing historical returns attributed to both credit and interest rate exposure help establish a risk profile. a. Returns attributed to credit exposure b. Returns attributed to interest rate exposure 15% 16% Trailing 12 Month Return 10% 5% 0% -5% -10% Trailing 12 Month Return 11% 6% 1% -15% -4% Sep-00 Sep-01 Sep-02 Sep-03 Sep-04 Sep-05 Sep-06 Sep-07 Sep-08 Sep-09 Sep-10 Sep-11 Sep-12 Sep-13 Sep-14 Sep-15 Prime money market index Ultra-short bond index Short-term credit index Notes: Charts represent hypothetical monthly gross return data for Vanguard-created, customized indexes based on Barclays POINT for a subset of our analysis period; September 2000 through Sources: Vanguard calculations, based on data from Barclays POINT. 14

15 As duration increases, federal funds rate level explains less return variation from interest rate exposure 100% 3 80% % Variation Explained 60% 40% 2 1 Average Duration 20% 0% Gov't money market index Prime money market index Ultra-short bond index Short-term credit index 0 Notes: This hypothetical illustration does not reflect returns of any specific investment. Data cover January 1992 through September Vanguard-calculated R-squared for each customized index represents percentage of variation from trailing-12 month duration matched U.S. Treasury bond returns that is explained by federal funds rate. Average duration is based on Barclays POINT calculation for the analysis period. Sources: Vanguard calculations, based on data from Bloomberg and Barclays. 15

16 Forward looking analysis using VCMM 16

17 Vanguard Capital Markets Model overview Economic factors Generate a distribution of long-term forecasts for an array of asset classes Distribution of asset returns Create custom set of portfolio solutions Client success objectives VCMM regression-based model Run 10,000 financial simulations distribution of volatilities Range of potential portfolios Historical data distribution of correlations Portfolio selection process *Statistical model supported with ongoing qualitative input from a team of quantitative specialists and grounded in Vanguard s time-tested investment philosophy 17

18 Negative returns increase in likelihood and magnitude as underlying maturity increases a. Potential for negative return a. Magnitude of potential return over one year 100% 40% Probability of an annualized negative return 80% 60% 40% 20% 0% 77% 19% 2% 3% Ultra-short bond index Short-term credit index Probability of annual negative return 30% 20% 10% 0% 4% 2% Ultra-short bond index 21% 4% Short-term credit index 1 Year 3 year -2% -4% Notes: These hypothetical illustrations do not reflect an specific investment. Money market indexes are not shown in this chart because they displayed less than 1% probability of loss over a one-year horizon. Sources: Vanguard calculations based on VCMM return forecast distributions as of December 31, IMPORTANT: The projections and other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from VCMM, derived from 10,000 simulations for U.S. equity returns and fixed income returns. Simulations as of December 31, Results from the model may vary with each use and over time. For more information, please see the important information slide. 18

19 Forward looking view suggests flatter yield curves and lower yield levels relative to history 6% 5% 4% Yield 3% 2% 1% 0% I year forward 3 years forward 5 years forward Post Jan '92 Average Notes: This hypothetical illustration does not reflect results of any specific investment. Chart reflects VCMM median yield-curve forecasts. Median projected yield curves over the cited horizons match forward yield curves implied by U.S. Treasury bond yield curve as of December 31, Sources: Vanguard, based on VCMM yield-curve forecast distributions. Post-January 1992 average is based on data from Thomson Reuters Datastream. 19

20 Conclusions 20

21 Conclusions U.S. investors are increasingly considering the trade-offs between money market funds and short-term bond vehicles for the management of their liquidity reserves. History suggests higher expected returns as investors add duration and credit risk to a bond portfolio a contention also supported by forward looking simulations from the Vanguard Capital Markets model. We see the additional risk from longer duration interest rate and credit risk as two-fold: a material increase in the probability for principal loss, and investor selection of active management in longer-term capital markets could lead to wider dispersion in return outcomes. To the extent that an investor s time horizon is longer than that of the benchmark, the risk of a longer-term option may be warranted. 21

22 Important Information For more information about Vanguard funds, visit institutional.vanguard.com or call to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing. An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund. All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss. Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments. IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time. The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based. The Vanguard Capital Markets Model is a proprietary financial simulation tool developed and maintained by Vanguard s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time The Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor of the Vanguard Funds. IGA913_

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