1 leadership series INVESTMENT INSIGHTS March 2015 Government Money Market Mutual Funds: An Attractive Option for Investors Seeking Capital Preservation and Liquidity Government money market mutual funds (MMFs) have been widely used by investors for decades as conservative cash-investment vehicles, primarily for principal stability, ready liquidity, competitive yields, and exceptional convenience. Historically, government MMFs have been preferred over prime MMFs 1 by investors who have sought to minimize exposure to credit risk in their short-term taxable investments and were willing to forgo a small amount of yield to achieve that objective. The categorization of government MMFs can apply to a range of fund types, of which the most broad in investment parameters are MMFs that can hold U.S. Treasury securities, government agency securities, and repurchase agreements collateralized by these same types of securities (see Exhibit 1, below). Throughout this paper, we refer to the government fund type. U.S. Treasury and government securities have two critical features that distinguish them from other security types: (1) they have very low credit risk; and (2) they are extremely liquid, even in times of severe market stress. These risk-reducing characteristics enabled government MMFs to weather the 2008 financial crisis extremely well, providing a cash investment option for those investors fleeing the uncertainty and volatility of the credit markets during that period. Since the financial crisis, government MMFs have become even more resilient as a result of the U.S. Securities and Exchange Commission s (SEC) 2010 and 2014 MMF reforms, which included significant amendments to Rule 2a-7. 2 As a leading provider of government MMFs, Fidelity has served the needs of investors for nearly 40 years, offering a broad spectrum of specialized, conservatively managed government MMFs. With more than $86 billion of government MMF assets under management, 3 Fidelity believes that the government sector of the MMF universe is poised for significant future growth, particularly in relation to prime MMFs in the wake of the SEC s 2014 money market regulations. EXHIBIT 1: Asset composition differentiates the four major types of taxable MMFs. KEY TAKEAWAYS Government money market mutual funds continue to serve investors as a reliable cash-investment vehicle by providing principal stability, ready liquidity, competitive yields, and exceptional convenience. Government money market mutual funds are eligible to price and transact at a stable $1.00 net asset value and are not subject to liquidity fees and redemption gates. Investors who believe that prime (general purpose) money market mutual funds those that invest primarily in corporate and bank debt may no longer meet their needs, post-2014 SEC regulatory changes, should consider government money market mutual funds as a preferable cashinvestment solution. Fund Type Treasury-Only Treasury Government Prime Source: Fidelity Investments. U.S. Treasury securities Typical Instruments Held U.S. Treasury securities and repurchase agreements collateralized by U.S. Treasury securities U.S. Treasury securities, other government securities, and repurchase agreements collateralized by U.S. Treasury or other government securities Any eligible money market instrument as defined by SEC Rule 2a-7, including all types listed above, as well as commercial paper, certificates of deposit, corporate notes, and other debt instruments
2 The enhanced appeal of government MMFs following 2014 SEC regulatory changes As anticipated, the SEC approved additional regulatory changes for MMFs in These amendments will take effect over a multiyear period; and, while government MMFs retained their key features, prime MMFs will experience modifications (see Leadership Series article, Key Money Market Mutual Fund Regulations 2014: Overview of Final SEC Rules, Jul. 2014). Under the new money market rules, government MMFs will be defined as funds that invest 99.5% of their total assets in cash, government securities, and/or repurchase agreements that are collateralized fully by cash items and government securities. Unlike prime MMFs, government MMFs will continue to be eligible to price and transact at a stable $1.00 net asset value (NAV) and will not be subject to the possibility of liquidity fees and redemption gates. 4 Meeting investor objectives The remaining sections of this paper address the four major money market investor goals of safety, liquidity, yield, and convenience. Each section provides additional detail about the advantages offered by government MMFs relative to other cashinvestment products in a post-reform marketplace. Government MMFs seek to provide principal stability In general, money market investors focus on managing three key risks: 1. credit risk the risk that an issuer of securities will default on its obligation to pay; 2. liquidity risk the risk that portfolio holdings cannot be converted to cash at par when cash is needed; and 3. market risk the risk that interest rates will rise or that historical relationships among key market rates will break down. The low-risk profile of government MMFs The primary holdings of government MMFs U.S. Treasury and government agency securities are generally perceived to have the lowest credit risk among all securities traded in U.S. debt markets. Moreover, during periods of market uncertainty, the liquidity of the holdings has actually improved as more investors seek refuge in these high-quality securities (see The probability of breaking the buck after the 2010 reforms, page 4). This flight-to-safety phenomenon has often caused the value of government MMF holdings to increase, which, in turn, strengthens the funds NAVs. Thus, this safety-seeking behavior has generally enabled government MMFs to avoid the negative market cycle that often takes hold during a crisis. Government MMFs can provide ample, ready liquidity The depth and breadth of the $6.6 trillion short-term government securities market provides a liquid investment universe for government MMFs (see Exhibit 2, above). Within this high-quality sector, EXHIBIT 2: Government MMFs account for a small portion of the short-term government bond universe. Short-Term Government Bond Universe ($bn) Treasury Bills A 1,458 Treasury Coupons (<1-yr. maturity) A 1,608 Treasury Floating-Rate Notes A 164 Primary Dealer Government Repurchase Agreements B 1,990 Fed Reverse Repurchase Agreements C 397 Agency Discount Notes D 602 Agency Coupons (<1-yr. maturity) D 357 Total 6,576 Government Money Market Funds E 943 Source: Data as of Dec. 31, 2014, unless otherwise noted. A U.S. Treasury, Monthly Statement of Public Debt. B Federal Reserve Bank of New York, Financing by Primary Dealers as of Jan. 28, C Federal Reserve Bank of New York. D Fannie Mae, Freddie Mac, Federal Home Loan Bank, Bloomberg. E imoneynet, as of Feb. 17, government MMF investments represented approximately 14% of the assets at the end of In the second half of 2008, institutional prime MMFs experienced heavy, sudden redemptions, which rapidly reduced their liquidity and caused them to sell a portion of their holdings often at a modest loss. By contrast, the market share prices and liquidity of government MMFs holdings generally increased during this period, as investors sought safety in government MMFs because of the EXHIBIT 3: Government MMFs, with their highly liquid composition and exceptional credit quality, attracted large inflows immediately following the Lehman bankruptcy in $ Assets in Billions /12/2008 9/19/2008 Source: imoneynet. 9/26/ /03/ /10/2008 ASSET FLOWS Institutional Government 10/17/ /24/ /31/ /07/ /14/2008 Institutional Prime 11/21/ /28/ /05/ /12/ /19/ /26/2008 2
3 EXHIBIT 4: The level and composition of weekly liquid assets in a representative government MMF surpass the minimum required by Rule 2a-7, as well as those of a representative prime MMF. PROPORTION OF FUND ASSETS (%) Weekly Liquid Government Instruments Weekly Liquid Non-Government Instruments 54.6% Government Fund Weekly Liquidity Weekly Regulatory Minimum: 30% 49.4% 24.1% 25.3% Prime Fund Weekly Liquidity Source: Fidelity, SEC Rule 2a-7. Government fund represented is the Fidelity Institutional MM Funds: Government Portfolio as of Jan. 31, Prime fund represented is the Fidelity Institutional MM Funds: Prime Money Market Portfolio as of Jan. 31, Note: The term weekly liquid, as used in the legend above, refers specifically to the set of instruments that meet the criteria for Weekly Liquid Assets as defined in Rule 2a-7. securities they held (see Exhibit 3, page 2). Typically, the liquidity levels of a government MMF far exceed the minimum levels required by Rule 2a-7, and they differ from those of a prime MMF in both quantity and quality. 5 Exhibit 4 (above) shows weekly liquid holdings for a Fidelity government MMF and a Fidelity prime MMF. The chart shows the differences in the composition of liquid holdings in each fund by indicating whether these holdings are government instruments or non-government instruments. Clearly, the composition of liquid holdings is influenced heavily by the investment choices available to the funds. Notably, government MMFs are required to invest primarily in Treasury securities, government agency securities, and repurchase agreements backed by these same securities, and Rule 2a-7 deems many of these instruments to be categorized as either daily or weekly liquid assets. Therefore, government MMFs tend to have higher liquidity levels than prime MMFs, because government MMFs have more restrictive investment parameters. Furthermore, most of a government fund s holdings that do not technically qualify as weekly liquid assets are government agency securities that have remaining maturities longer than 60 days. These securities are still very liquid, and in fact exhibit liquidity characteristics similar to those of U.S. Treasury securities. Interest-rate risk constrained As we have demonstrated, government MMFs offer investors a cashmanagement vehicle with very low credit and liquidity risk. As with all debt portfolios, government MMFs do have exposure to changes in interest rates; however, the 2010 amendments to Rule 2a-7 further reduced this risk by limiting the weighted average maturity 6 of a MMF to a maximum of 60 days (significantly lower than the former limit of 90 days). The 2010 reforms also helped to mitigate certain types of spread-widening risk 7 by limiting the weighted average life 8 of a MMF to a maximum of 120 days, which constrains MMF holdings of long-dated floating-rate securities. Government MMFs typically offer a competitive yield As shown in Exhibit 5 (below), government MMFs have provided a significant and consistent yield advantage over bank money market deposit accounts through most interest-rate cycles during the past 20 years. In the ultra-low-rate environment of the past several years, the advantage of government MMFs over these bank accounts has been reduced, but this advantage is expected to increase as monetary policy is normalized. The advantage stems from the fact that government MMFs pass along a marketbased yield that is closely tied to the prevailing interest rates paid on short-term investments. Banks, on the other hand, pay an administered rate that most often is significantly below current short-term market rates. Government MMFs have also had competitive yields when compared with prime MMFs. Exhibit 6 (page 4) shows a time series of the difference in yield yield spread between prime and government MMFs during the 20-year period ending Dec EXHIBIT 5: Government MMFs have provided a significant and consistent yield advantage over bank accounts through most interest-rate cycles. Net Yield (%) HISTORICAL YIELDS Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Prime (all) Government (all) Bank Deposit Account Notes: MMF yields shown are average month-end net 7-day annualized yields reported by imoneynet for all prime and government money market funds. Bank rates shown are estimates generated by the Investment Company Institute based on data from Bankrate.com. Source: imoneynet, Investment Company Institute, Bankrate.com. Data as of Dec. 31, Past performance is no guarantee of future results. Unlike most FDIC-insured bank products, a money market fund s yield and return will vary. An investment in the fund is not insured or guaranteed by the U.S. government. 3
4 It also includes a histogram of spread frequency for the same period. The yield difference between prime and government MMFs averaged about 6 basis points (bp) for much of the period, the exception being the two years spanning the financial crisis, when elevated levels of credit risk forced many investors from the credit markets into less risky assets. 9 The histogram shows that, for about 66% of the period, the difference in yield between government and prime funds was 10 bp or less; moreover, for nearly 83% of the period, this difference in yield was only 15 bp or less. These yield differences are nominal they have been calculated directly without any adjustments. The risk-adjusted yield differences would be even smaller, since government MMFs generally have higher credit quality and higher liquidity than do prime MMFs. Moreover, although investors may tend to attribute disproportionate importance to a 10 bp 15 bp difference in the current ultra-lowyield market environment, it is worth noting that, for 40% of the period depicted in Exhibit 6, prime and government money market yields actually exceeded 4%, making this yield difference a relatively small premium to forgo for the risk-reducing benefit gained. The 2014 money market reform rules may increase the demand for government MMFs, which could also increase the demand for government securities. If this is the case, it is possible that the EXHIBIT 6: The yield difference between government and prime MMFs was 10 bp or less 66% of the time for the 20-year period ending Dec. 31, Yield Spread (bp) HISTORICAL DISTRIBUTION OF YIELD SPREAD 5.8% % GOVERNMENT VS. PRIME MMFs 15.0% 16.3% 4.6% Historical Distribution 3.8% 1.7% 2.1% 2.1% 1.3% Yield Spread (bp) % 0.8% Notes: Yield spread is the difference in average month-end net 7-day annualized yields reported by imoneynet for all prime and government money market funds. A basis point (bp) is one one-hundredth (1/100 or 0.01) of one percent. Source: imoneynet, as of Dec. 31, Past performance is no guarantee of future results. yield spread between prime MMFs and government MMFs may increase. However, it is unlikely to change the value proposition that government MMFs will offer. Investment implications Investors have long shown a preference for using MMFs as their primary cash-management vehicle, as evidenced by the $2.7 trillion currently invested in MMFs despite their low yields. 10 Government MMFs stability supported by high-quality and liquid holdings with limited interest rate risk along with their competitive yields and ease of use can be an attractive cash-management solution for investors. Additionally, the eligibility of government MMFs to price and transact at a stable $1.00 net asset value and their freedom from liquidity fees and redemption gates, distinguishes them in the money market fund universe. The probability of breaking the buck after the 2010 reforms Further compelling evidence of the risk-reducing properties of Treasury securities was provided by the SEC in its 2012 study of MMFs. A For that study, the SEC produced a model (denoted Model A-2 ) of a generic MMF that could allocate a variable percentage of its assets 0% to 100% to Treasury securities. The SEC study showed that a fund with just 50% of its assets allocated to Treasury securities, when exposed to both interest rate risk and credit default risk, had a nearly zero probability of breaking the buck (see Exhibit A, below). Approximately one-third of government MMFs held more than 50% Treasury securities at the end of 2014 (Treasury funds have close to 100% in Treasuries); B moreover, the remaining securities held were government agency securities, which exhibit interest rate risk and credit default risk nearly identical to that of Treasuries, further strengthening the risk profile of these funds. EXHIBIT A: An SEC study showed a dramatic decline in the probability of breaking the buck after the 2010 reforms, and that a 50% allocation to Treasury securities makes this probability nearly zero. Proportion of Portfolio Invested in Treasury Securities Probability of NAV <$ WAM = 90 Days WAM = 60 Days 100% 0.00% 0.00% 50% 0.00% 0.00% 0% 0.92% 0.18% Source: SEC study, Response to Questions Posed by Commissioners Aguilar, Paredes, and Gallagher, authored by the Division of Risk, Strategy, and Financial Innovation, Nov. 30, WAM = weighted average maturity, NAV = net asset value. 4
5 Before investing in any mutual fund, please carefully consider the investment objectives, risks, charges, and expenses. For this and other information, contact Fidelity for a free prospectus or, if available, a summary prospectus. Please read it carefully. An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund. Interest rate increases can cause the price of money market securities to decrease. Past performance is no guarantee of future results. Current and future portfolio holdings are subject to risk. The current yield reflects the current earnings of the fund, while the total return refers to a specific past holding period. Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the authors and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information. Investment decisions should be based on an individual s own goals, time horizon, and tolerance for risk. Endnotes 1 Prime money market mutual funds primarily invest in high-quality, U.S. dollar denominated, short-maturity corporate debt securities. 2 Rule 2a-7 of the Investment Company Act of 1940 regulates how all U.S. money market mutual funds are managed. 3 Assets under management are as of Dec. 31, The final rules are clear that liquidity fees and/or redemption gates do not apply to U.S. Treasury or government money market mutual funds. 5 These categories represent, respectively, the proportion of fund assets that can be converted readily to cash within one day or one week and are defined as Daily Liquid Assets and Weekly Liquid Assets under Rule 2a-7. 6 Weighted Average Maturity (WAM) - This is a weighted average of all the maturities of the securities held in a fund. WAM can be used as a measure of sensitivity to interest rate changes and market changes. Generally, the longer the maturity, the greater the sensitivity to such changes. WAM is based on the dollar-weighted average length of time until principal payments must be paid. Depending on the types of securities held in a fund, certain maturity-shortening devices (e.g., demand features, interest rate resets, and call options) may be taken into account when calculating the WAM. 7 Specifically, the weighted average life constraint in Rule 2a-7 implicitly controls the risk that a floating-rate instrument structured to pay a fixed spread relative to a fluctuating benchmark rate (such as the federal funds effective rate) would decline in market value in the event that market participants later require a much higher spread to be enticed to buy a similar instrument. 8 Weighted Average Life (WAL) - For money market funds, this is the weighted average of the life of the securities held in a fund or portfolio and can be used as a measure of sensitivity to changes in liquidity and/ or credit risk. Generally, the higher the value, the greater the sensitivity. WAL is based on the dollar-weighted average length of time until principal payments must be paid, taking into account any call options exercised by the issuer and any permissible maturity shortening features other than interest rate resets. For money market funds, the difference between WAM and WAL is that WAM takes into account interest rate resets and WAL does not. WAL for money market funds is not the same as WAL of a mortgage- or asset-backed security. 9 In this analysis, we define the financial crisis as the two-year period ending Jul. 31, imoneynet, as of Dec. 31, A Response to Questions Posed by Commissioners Aguilar, Paredes, and Gallagher, Division of Risk, Strategy, and Financial Innovation, U.S. Securities and Exchange Commission, Nov. 30, 2012, available at B For the weekly reporting period ending Dec. 31, 2014, the imoneynet Money Fund Report shows that 101 out of 321 funds in the Government Institutional category had U.S. Treasury holdings greater than or equal to 50% of assets. Third-party marks are the property of their respective owners; all other marks are the property of FMR LLC. 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