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Money funds follow the same doctrine as fixed income funds: In a declining rate environment, funds with long weighted average maturities should outperform because longer maturity fixed rate assets prop up portfolio yields. It is one of the reasons that money funds remain popular investment vehicles for investors as rates fall. So what happened?
—Todd N. Bean, Head of US Traditional Cash Strategies
Traditional portfolio management doctrine suggests that a fixed income fund should be long duration in a declining interest rate environment. The concept applies to even the shortest of duration fixed income fund: money funds. In a declining rate environment, funds with long Weighted Average Maturities (WAMs) should outperform because longer maturity fixed rate assets prop up portfolio yields. It is one of the reasons that money funds remain popular investment vehicles for investors as rates fall. This is especially true versus competing products like bank deposits, which tend to immediately reset lower after the Federal Reserve (Fed) cuts administered rates. However, during the Fed’s recent 75 basis point (bps) mid-cycle adjustment, money funds’ WAMs remained relatively short compared to the maximum allowable level of 60 days. Crane Data’s Government Institutional Money Fund Index showed WAMs of just 26, 25, 28 and 30 days as of month-end in July, August, September, and October, respectively.1 Crane Data’s Prime Institutional Money Fund Index showed WAMs of 33, 35, 33 and 33 days over those same months.2
The answer begins all the way back in December of 2018, when the Fed released its updated summary of Economic Projections at the year-end Federal Open Market Committee (FOMC) meeting. At that meeting, the Fed raised its target range for rates by 25 bps to 2.25%–2.50% and its dot plot at the time showed median expectations of another 50 bps in hikes during 2019 and one last 25 bps hike in 2020.3 Given those expectations, money funds positioned in significant barbells with heavy allocations to overnight repurchase agreements (repo) and longer maturity floating rate notes were very comfortable with their strategy. Asset allocations, at that time, resulted in low WAMs and ample liquidity ready to take advantage of higher expected rates. However, as trade tensions escalated rapidly, global growth slowed and investor sentiment rolled over, the market quickly began pricing in a different path for rates.
Money fund portfolio managers determine the relative value of longer maturity fixed rate trades by comparing the offered rate for a particular maturity to expected overnight repo rates over the same time period. If the term rate exceeds the calculated breakeven rate of overnight rates, the trade is determined to have value. As global economic data deteriorated, traders quickly flattened yield curves. The window to take advantage of positive breakeven rates closed swiftly. Inverted money market curves (from the Fed Funds Futures market to the curves for both rates and credit) emerged shortly thereafter. Suddenly, a healthy debate over appropriate monetary policy surfaced. Many economists and strategists began making the case that the US economy was fundamentally too strong to justify pricing in an imminent Fed ease. Traders continued to push rates lower, testing the efficacy of the perceived Fed put. Ultimately, the Fed confirmed trader sentiment, defied strong fundamentals and acquiesced to delivering several insurance rate cuts.4
While that debate was happening at the macro level, banks and dealers visited investors to talk about concerns that were simmering quietly in the funding markets. While the Fed continued to shrink its balance sheet and drain reserves from the financial system, US fiscal policy dictated heavy Treasury borrowing needs. Regulatory constraints that were implemented following the Global Financial Crisis limited the dealers’ ability to absorb both conditions simultaneously forever. The combination of these factors often left dealers with hefty inventories and balance sheets operating near full capacity. For money fund portfolio managers, this set expectations of repo rates continuing to creep higher within the Fed target range as the year progressed. Portfolio managers asked themselves if it was possible that overnight repo rates would continue to outperform, even after a potential 25 bps rate cut. Elevated overnight estimates for repo rates in breakeven analysis made it harder to justify investing in longer maturities. This was particularly true when combined with concerns about the state of secondary market liquidity in the face of the funding market pressure. These apprehensions were not unfounded and came to fruition on September 16, the corporate tax date this year, during the repo market disruption. During this time, funding market rates increased significantly: General Collateral repo rates reached 10% and the Secured Overnight Financing Rate (SOFR) increasing by over 300 basis points in two days.5
Another challenge facing money fund portfolio managers was an increased focus on current yield. The changing face of distribution models, including the growth of financial intermediary portals and the daily transparency provided by fund families and data providers, has increased the competitive landscape for money funds. Savvy institutional investors pay very close attention to 1-day and 7-day yields and can efficiently make changes to their allocations between funds and fund families with a click of the button. This makes money fund managers sensitive to preventing drops in current yield. In a declining rate environment, when facing an inverted yield curve, there is less incentive to term out assets because it immediately depresses the current yield. This short-sighted view may benefit current yield today while missing potential upside down the road. Money fund portfolio managers have to balance both worlds.
Regulatory changes that went into effect following the Global Financial Crisis also played a role in why funds were so short. The implementation of potential fees and gates tied to a fund’s weekly liquid assets changed how Prime money fund portfolio managers construct portfolios. To avoid any risk of flirting with minimum requirements, Prime money funds target weekly liquid asset levels around 40%. This biases portfolio WAMs lower. In order to extend WAM, more assets have to be invested in longer maturities for a barbell strategy. The timing of establishing the fund’s barbell is always very important. The risk remains if trade policy progress was made while the domestic economy continued to grow, the Fed could pause. There’s a risk a fund could get long while the market was pricing in cuts, only for the Fed to stop easing. This has the potential to depress portfolio yields over an even longer time frame. Instead, if a fund hedged with a more laddered approach to new purchases, the fund is protected against the Fed changing tune, but at the cost of a lower WAM. Government money funds were also affected by the post-Global Financial Crisis regulatory reforms but in a very different way. The asset migration out of Prime money funds left the bulk of money market cash in Government strategies. Trying to change portfolio strategy in very large funds can be challenging and at the mercy of issuer supply. In a market that prices in
changes to rate expectations almost instantaneously, scale can hinder how nimble a portfolio is and how quickly it can change strategy.
Last, but certainly not least, was money market assets under management (AUM) grew massively throughout the year, both in Prime and Government strategies. Institutional Government money funds’ AUM, year-to-date through October 31, 2019, increased by $181 billion.6 Prime Institutional money funds’ AUM rose by $244 billion over the same timeframe.7 The drivers of the cash inflows varied between corporate deal flow, fixed income investors shortening duration due to the inverted yield curve and risk aversion to equities at all-time highs among others. Cash inflows in a declining rate environment are a bit of a winner’s curse as new assets drag down duration metrics, increase liquidity and lower portfolio-level yields. Even as the new cash pushed yields lower, investors continued to invest in the funds. Determining how long new assets will stay invested in money funds is very important to the positioning of said funds. Trusting that the cash is “sticky” allows you to invest out the curve and take advantage of term premiums if and when they exist. In the absence of that confidence, or if the stated timeline of the investment is short-term, investors are biased to keeping liquidity on hand.
Regulatory changes, repo market concerns, rapid increases in AUM, Fed uncertainty and a focus on current yield all contributed to why money funds remained short during the recent decline in rates. Balancing all of these factors, while focusing on the trident of investment objectives for money fund managers (preservation of principal, providing daily liquidity and competitive yields consistent with current income) resulted in a challenging 2019.
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