There’s Still Time to Move to Prime

In last year’s Global Cash Outlook, we observed that many investors were considering moving some of their cash back into prime money fund strategies. Indeed, prime money fund assets under management (AUM) continued to grow in 2019, rising to $750 billion in November 2019, up from $536 billion a year earlier, and more than double from the low of $372 billion in the weeks after the October 2016 money fund reform deadline.¹ This continues to support the observation that investors are comfortable with how prime money funds operate. We believe companies that invest exclusively in government money funds would be wise to weigh the prime fund yield benefits against the incremental risks inherent in these funds, and consider allocating to them.

Institutional prime money funds carry certain risks (discussed below) that government money funds don’t. We believe that the risk/return profile offers value for investors with a slightly longer time horizon. A $100 million investment in a prime money fund would have returned $690,000 more than the same investment in a government money fund in the three years since money fund reform; ² over the past year it would have returned $170,000 more.³

We expect the spread to continue rewarding prime money fund investments. In aggregate, the yield difference between institutional prime and government funds has ranged from 12 basis points (bps) to 26 bps during 2019 (excluding the anomalous week of Sept. 16, whenthe differential shrank to 4 bps due to a repurchase agreement market spike). At the timeof this writing in mid-December, the spread stood at 22 bps. The spread has contracted from the post-money fund reform wide of 2017 (36 bps) and tax reform wide of 2018 (30bps). Still, we expect the spread to widen and tighten over time, as market events impacts hort-term rates. Given this fluctuation, we believe that it makes sense to keep at least some cash not required for immediate needs in prime money funds, to benefit from this spread.

Among the most significant regulatory changes enacted by the money fund reform was the requirement that institutional prime money funds move from a fixed, dollar-per-share net asset value (NAV) to a variable NAV fund price. The change, intended to more accurately reflect the value of the assets in a money fund, raised concerns that 100% of the principal deposited in a money fund may not be available when redemptions were needed, if the NAV declined in value.

The record over the past three years has helped to allay these concerns. During this time, we have seen only incremental NAV movements, which have been more than compensated for by excess return from the yield differential between variable NAV prime money funds and fixed NAV government money funds.

Prime money fund NAV changes have been small and infrequent. We examined 27 funds since just after reform of December 2016. The largest price range in any fund over that period was 8 bps ($1.0007–$0.9999) and the smallest move was zero, or no move at all. With rare exceptions, when prime money fund NAVs move, they do so in increments of 1 basis point ($0.0001). We found 8 instances of a 2 bps ($0.0002) move, and we have not observed any that have moved more than 2 bps at a time.

This NAV stability has persisted even amid instability in short-term interest rates. In the three years since the new money fund rules went into effect, the Federal Funds Target Range has risen by 200 bps, and then fallen by 75 bps — the latter in just 4 months’ time. NAV stability has also been tested by other noteworthy events — such as unprecedented Treasury issuance, yield-curve inversions, volatility in the Libor-OIS spread (a proxy for credit conditions), quantitative tightening, and large-scale bond selling fueled by the 2017 tax cuts. Additionally, over the past 12 months, prime money fund AUM rose by more than $110 billion, putting pressure on portfolio managers to invest that cash while maintaining a stable NAV. On average, however, fund price changes have occurred only 1.7 times per month from December 2016 to November 2019. During the particularly volatile period of November 2018 to November 2019, the rate ticked up to 2.6 moves per month. Still, the prime money fund yield differential over government money funds more than compensated all but the shortest-term investors for these NAV changes.

The other major changes that emerged with money fund reform include minimum liquidity requirements and provisions for redemption fees and liquidity gates in the event that a fund is not able to meet the minimum liquidity requirements. To review, prime money funds are required to maintain at least 10% in daily liquidity and 30% in weekly liquidity. If liquidity falls below these levels, a fund’s board is authorized to impose fees of up to 2% and/or redemption gates, if it believes that doing so is in the best interest of the fund’s shareholders (for instance, to prevent asset runs).

In general, portfolio managers are giving a wide berth to these thresholds. We examined some of the largest prime money funds and found weekly liquidity levels well in excess of the 30% required by the SEC. Some funds hold more than 40% of their AUM in such assets. In addition to the regulatory requirements for liquidity that far exceeds pre-reform levels, we have observed industry-wide pressure to maintain high liquidity, for the overall health of the industry. Fund managers understand that a liquidity shortfall at any single fund would likely harm the reputation of all institutional prime money funds, regardless of their liquidity levels. Taken together, we believe that investors are far better protected from risk in prime money funds today than they were prior to reform.

Even though the prime-to-government fund yield spread has compressed over the past year, prime money fund investors are still well rewarded for the incremental extra risk inherent in the credit exposure and floating NAV. The safety and liquidity of these vehicles remains robust. Balancing risk and reward, we believe that it makes sense to allocate a portion of a company’s cash to prime money fund strategies.