March 2015 » White paper
Bonds or bond funds?
reform
and the
Why Money
a bond fundmarket
might be the
better choice
for most
clients
short
end of the bond market
Michael V. Salm
Co-Head of Fixed Income
Jo Anne Ferullo, CFA
Senior Investment Director
Joanne M. Driscoll, CFA
Portfolio Manager
Key takeaways
The transformation of U.S. money markets
•New Rule 2a-7 money
market reforms were
enacted by the SEC in
2014 to address concerns
regarding potential “runs”
on money market funds.
•The new reforms mandate
tests and triggers for
redemption fees and gates,
among other measures.
•As the regulations are
implemented, volatility
at the short end of the
yield curve may increase
as retail and institutional
investors recognize the
relative attractiveness of
government money market
funds without any fees
and gates.
Recent money market reform, as well as the ongoing process of systemic
regulatory change in the nation’s financial infrastructure, is having an impact
on the overall liquidity of U.S. markets, much of which is squarely focused on
the front end of the U.S. Treasury yield curve. In this first paper of a two-part
series, we examine the market conditions that primarily motivated recently
enacted money market reform and outline the key changes embedded in
these new rules, including any potential downstream market effects that we
think they may be likely to cause.
After several years of debate, the most recent set of money market
reform measures were finally voted into reality in the summer of 2014.
On July 23, 2014, the SEC approved final rules that amend Rule 2a-7, the
governing regulation for money market funds. A narrow 3–2 vote set in
motion the implementation of rules that had been under debate for several
years. The rules became effective October 13, 2014. The implementation
period is staggered from nine months to two years. This long time frame
is certainly needed as market participants have nearly 1,000 pages of rule
changes to digest and implement, including in investor disclosures and
educational material, on web-based platforms, and within fund providers’
internal systems.
Money markets in crisis
The rule changes were enacted in order to protect money market funds,
and thus the financial markets, from a potential “run” if there is another
crisis similar to that which we experienced beginning in 2007. The credit
crisis primarily manifested itself in the short end of the market in two ways:
first, with investors backing away from the asset-backed commercial paper
(“ABCP”) market, and second, when the Reserve Primary Fund “broke the
buck” as a direct result of the Lehman bankruptcy on September 15, 2008,
and the subsequent price markdown of its Lehman debt holdings.
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MARCH 2015 | Money market reform and the short end of the bond market
Commercial paper under pressure
Interestingly, retail funds saw net inflows during this
time as retail investors sought safety, while it was
the prime institutional money market funds that
experienced over $170 billion in net outflows from
September 15 to 17, 2008. The majority of that outflow
moved into government institutional money market
funds. This is the key reason why the new 2a-7 rules
differentiate between the retail and the institutional
investor, and are imposing the floating NAV on institutional money market funds rather than retail funds.
Various types of ABCP came under extreme pressure
in the summer of 2007 after two Bear Stearns hedge
funds that invested in subprime mortgages filed for
bankruptcy. Shortly thereafter, three BNP Paribas assetbacked bond funds* suspended redemptions due to their
inability to adequately assess the value of the mortgages
(approximately one third of the funds were invested in
subprime) and other investments held by those funds.
ABCP may be backed by a variety of collateral (e.g., trade
receivables); in 2007, some ABCP deals were also backed
by subprime mortgages. As a consequence of the Bear
Stearns and BNP Paribas events, investors generally
moved away from the ABCP market broadly, regardless
of collateral type, which triggered substantial credit and
liquidity pressures in that market. From August 2007
to August 2008, the amount of ABCP outstanding fell
from $1.2 trillion to $745 billion — a 37% decline1 as these
short-term instruments matured and were not renewed
(“rolled over”) as would normally have been the case.
Commercial paper is a corporate linchpin
Beyond these more obvious impacts is the trickle-down
effect that a run on money market funds could precipitate. Money market funds are the primary buyers of
CP. If there is a run on the money market fund system,
money market funds will be working to raise cash, not
invest it. Commercial paper debt is issued by many
companies in order to fund themselves over short time
periods, typically no longer than 270 days, or about
nine months. Those funding needs tend to be fairly
consistent, so companies will simply “roll over” their
CP — when the security reaches maturity, a new one is
immediately issued, effectively rolling that debt to a new
maturity date in the future. In a liquidity event, money
market funds could pull away from the CP market and,
left without the cash on hand to pay off their short-term
CP debt, companies will be faced with a lack of liquidity
and will need to turn to other sources.
The buck breaks
In September 2008, under severe pressure from the
bankruptcy of Lehman Brothers, the Reserve Primary
Fund — the oldest U.S. money market fund — saw the
net asset value (“NAV”) of its shares fall to 97 cents
from the supposedly rock-solid $1.00 NAV. This was
the second major crisis-driven event to impact the
short end of the market. This announcement drove
a wave of highly publicized redemptions by jittery
institutional investors from money market funds and
short-term funds, which were forced to liquidate assets
or impose limits on redemptions. Even though the U.S.
government decided to provide deposit insurance to
investments in money market funds and the flood of
redemptions slowed drastically, many money market
funds chose to reduce their holdings of any traditional
commercial paper (“CP”) they believed their investors
might perceive as too risky. By mid-October 2008, what
had been $1.8 trillion outstanding in CP fell by 15% to
$1.43 trillion.2 This precipitous decline in the CP market
was halted only when the Federal Reserve began
purchasing commercial paper directly from CP issuers.
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Many companies have bank lines of credit to fall back
on, but these are more expensive and have limitations
on the amount that may be drawn. Companies without
backup sources of liquidity (or whose liquidity needs
exceed their backup facility) and with no way to quickly
raise money, may default on their CP debt and/or other
short-term obligations. Without short-term funding or
readily liquid assets on hand, the companies may have
to declare bankruptcy. Given the widespread use of CP
for short-term funding (in early 2007, before the crisis,
there was $1.97 trillion in outstanding CP3), the potential
exists for significant bankruptcies to occur, creating a
downward spiral and serious economic damage.
2
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Post-crisis regulations: The first wave
of change
The third significant liquidity requirement was the
change in the allowable level of credit quality; this
reduced the amount permitted to be purchased of what
is referred to as Tier 2 or A-2/P-2 rated (roughly equated
to BBB) securities to 3% of net assets versus what had
originally been 5%. This quality limitation has created a
dislocation between the higher-rated money-marketfund-eligible securities and short-dated BBB-rated
securities — a potential opportunity for gaining additional yield for funds not managed under Rule 2a-7.
In 2010, the SEC made their first round of changes to
Rule 2a-7 in response to the impacts of the credit crisis.
This initial set of rule changes were intended to hone in
on increasing the resiliency of money market funds to
economic stresses. We believe that, among the changes
made at that time, the most important updates were
ensuring that money market funds maintained a high
degree of liquidity and highlighting the “shadow,” or
market value, NAV of a money market fund.
Lastly, stress testing was required for the actual market
value (or “shadow”) NAV of money market funds, which
represents what the fund’s NAV would be if its securities were priced according to market value as opposed
to amortized cost pricing. The goal of stress testing is
to measure a money market fund’s ability to maintain
a $1.00 NAV in the event of shocks to the market. The
stress testing is meant to identify the potential for any
one money market fund to “break the buck,” or fail to
provide investors with transactions valued at $1.00 NAV.
Additionally, the actual shadow NAV was also required
to be reported to the SEC and then made available to
the public 60 days later. This requirement put a bright
light on the shadow, or market value, NAV of a money
market fund, which many typical investors were not
even aware existed.
Shorter WAM, higher liquidity, stress testing
With the goal of ensuring liquidity, the SEC insisted on
three points. The first focused on the weighted average
maturity (“WAM”) of money market funds. The SEC
under Rule 2a-7 has always proscribed the WAM of a
money market fund; before the 2010 changes, it was
90 days. The new change mandated the WAM to be
no longer than 60 days. While a one-month change,
as interpreted by the casual observer, may not seem
to matter much, it was a significant change for money
market funds because it reduced the WAM by 33%.
Figure 1. Weighted average maturity (days)
90
Pre Rule 2a-7
Post Rule 2a-7
Post-crisis regulations: The second wave
of change
60
The new SEC 2014 changes for Rule 2a-7 allow the potential implementation of redemption fees and gates should
a money market fund’s weekly assets fall below the 30%
threshold. This is intended to stem the tide of potential
redemptions for retail and institutional non-government
money market funds in times of market stress, helping
to ensure that money market funds do not retreat from
the market en masse. By allowing fees and gates, the
mechanism is in place for money market fund Boards to
opt to reduce the amount of redemptions by imposing
a fee, thereby creating a deterrent for investors to
redeem, and/or to halt redemptions for a specific period
of time, thereby enabling money market funds to avoid
becoming forced sellers into a deteriorating market.
Source: Securities and Exchange Commission.
The second point was the brand new provision
mandating liquidity requirements that now specified
that money market funds maintain a minimum of 10%
in daily liquidity and that 30% of the fund must be
liquid within seven days (certain securities with longer
maturities also meet the criteria). The updated WAM
and new liquidity requirements pushed money market
fund demand even shorter on the yield curve, which has
added to the downward pressure on the level of yields
for shorter maturities.
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MARCH 2015 | Money market reform and the short end of the bond market
Redefining money market funds
the two-decimal $1.00 NAV; likewise, if a tax-exempt
money market fund is deemed institutional, it will
transact using a four decimal NAV.
The amendments addressed three major topics of
concern as well as updated a number of other areas of the
regulation. The three major topics are 1) officially defining
various types of money market funds, 2) requiring a
floating NAV for certain “non-retail” money market funds,
and 3) allowing the imposition of redemption fees and
gates. While not all the rules impact every type of money
market fund in exactly the same way, all money market
funds will be affected by the latest cycle of changes.
3.Redemption fees and gates
Money market funds are required to maintain 30%
in weekly liquid assets (i.e., assets maturing in seven
days or less). There are two types of redemption fee
scenarios that apply to both retail and institutional
money market funds, though not to government money
market funds unless they opt in and have disclosed that
choice in a prior prospectus.
1. Money market fund definitions
a.Retail funds: The new rules define a “retail” money
market fund to be a fund with policies reasonably
designed to limit its investors solely to “natural
persons.” The fund industry will be working with
the SEC to provide further definition for the categories of investors eligible to invest in “retail” funds.
a.If the money market fund’s weekly liquidity falls
below the required 30%, the fund’s Board has the
discretion to impose a maximum 2% redemption fee if
it decides it is in the best interest of the fund to do so.
b.Additionally, if the weekly liquidity falls below
10% there is a default redemption fee of 1% that is
imposed automatically unless the fund’s Board
decides it is in the fund’s best interest to not impose
that fee or to impose a higher fee of up to 2%. Once
the 30% weekly liquid asset test is again met, the fees
automatically stop.
b.Institutional funds: Non-retail, or institutional,
funds are defined as funds with beneficial
owners who are not “natural persons” but entities,
such as corporations, partnerships, certain trust
structures, etc.
c.Retail and institutional tax-exempt funds:
Tax-exempt money market funds will also follow
the retail versus institutional rules.
A gate means that a fund temporarily suspends
redemptions. If the fund’s weekly liquidity falls below
30% and remains below 30% for up to 10 business days,
the fund’s Board may temporarily suspend redemptions if it determines that it is in the best interest of the
fund. The gate may only be imposed for the shorter of
10 days or until the weekly liquidity returns to at least
30%. The gate may only be used for up to 10 days during
any 90-day period. This is applicable to both retail
and institutional money market funds, although not to
government money market funds unless they opt in and
have disclosed that choice in a prior prospectus.
d.Government funds: The new rules also define a
“government” money market fund to be a fund with
99.5% of its assets invested in cash, U.S. government
securities, and/or repurchase agreements that are
collateralized by U.S. government securities.
2.Floating NAV
Under the new rule, only retail and government money
market funds may utilize the rounded two-decimal
NAV, which under normal circumstances allows a
fund to maintain a stable $1.00 NAV. Non-retail funds
(other than government funds) will be required to use
a four-decimal NAV. The additional two decimal points
Additional second-wave changes
Beyond these major changes, a number of other
changes refining diversification, disclosure, and stress
testing (among others) are also being implemented.
Depending on the change, the implementation period
may range from nine months to two years from the
October 2014 effective date. The three major changes
outlined above are to be implemented in two years.
eliminate the ability of institutional non-government
funds to strike a $1.00 NAV; their NAV will float based
on the four-decimal NAV. If a tax-exempt money market
fund is deemed to be retail, it may continue to maintain
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The regulatory transformation of money market funds
Fund differentiation
Prime institutional
Retail
Government (retail
or institutional)
Tax exempt (retail
or institutional)
Definition
No “natural persons”; only
institutions
Beneficial owners limited
to “natural persons”
99.5% invested in cash,
government securities,
100% governmentcollateralized repo
Institutional and retail
definitions apply
Floating NAV
Floating
$1.00
$1.00
Institutional and retail
definitions apply
Redemption fee
Based on weekly liquidity:
Based on weekly liquidity:
Based on weekly liquidity:
If <30%, max 2% fee at
board discretion
If <30%, max 2% fee at
board discretion
May opt in with prior
prospectus disclosure
If <10%, 1% fee required,
unless board removes or
increases up to 2%
If <10%, 1% fee required,
unless board removes or
increases up to 2%
Based on weekly liquidity:
If <30%, board may
suspend up to 10 days
Based on weekly liquidity:
If <30%, board may
suspend up to 10 days
Gates
If <30%, max 2% fee at
board discretion
If <10%, 1% fee required,
unless board removes or
increases up to 2%
May opt in with prior
prospectus disclosure
Based on weekly liquidity:
If <30%, board may
suspend up to 10 days
All funds are required to comply with new disclosure and reporting, diversification, and stress testing requirements.
Anticipated market impacts
their assets into a suitable money market fund, while others
may consider the broader universe of the growing category
of ultra-short funds. A number of investors may choose to
redeploy assets into completely different strategies outside
of short-dated fixed-income assets. The splitting up of assets
based on investor type may thus force potentially material
fund flows, both within the money market fund universe and
outside it. Consequently, these flows may amplify market
volatility, depending on the magnitude of movement and the
types of assets being traded.
With a long transition period to implement the various
reforms, the likelihood of significant market change in the
near term is low. However, over time the short end of the
market may become markedly different from how it is today.
Some effects engendered by reform will be fairly obvious —
such as greater demand for government securities — while
others will be more subtle, such as the potential flow effect
related to increased disclosure of fund liquidity.
The first and most obvious impact of the reform stems
from the definition of the types of money market funds and
the application of the floating NAV. Differentiating between
retail and institutional investors in and of itself does not wreak
havoc on the system. However, we believe that eliminating
the floating NAV for institutional investors may create significant transitional effects. Fund companies will need to review
their full investor base to differentiate their institutional
versus retail investors, and will likely designate an existing
money market fund as either retail or institutional. Those
investors who do not fit within the designated definition of
their current money market fund investment will need to
redeem their shares and will be faced with a choice regarding
a new investment for those assets. Some investors will move
Additionally, with the definition of government money
market funds changing, from maintaining at least 80%
government assets to increasing that minimum level to
99.5%, it is clear there will be more demand for short-term
government assets. Since 2008, with the exception of one
year, U.S. Treasury bills outstanding have decreased each
year. Combined, the decline in outstanding bills from 2009
through the end of 2014 is $404 billion. If institutional investors opt for government money market funds in order to
maintain the $1.00 NAV, demand for short -term government assets would be even greater. Less supply and greater
demand typically translates into lower yields, which will
continue to pressure rates at the short end of the yield curve.
5
MARCH 2015 | Money market reform and the short end of the bond market
Annual U.S. Treasury bill issuance and outstanding
SIFMA year to date 12/31/14 (USD billions)
Year
Gross issuance
Outstanding
Change
1998
$759.1
$691.0
­—
1999
—
737.1
$46.1
2000
1,725.4
646.9
-90.2
2001
2,362.5
811.2
164.3
2002
3,241.0
888.7
77.5
2003
3,503.3
928.8
40.1
2004
3,836.4
1,001.2
72.4
2005
3,615.7
960.7
-40.5
2006
3,632.7
940.8
-19.9
2007
3,742.3
999.5
58.7
2008
5,627.7
1,861.2
861.7
2009
6,417.7
1,793.5
-67.7
2010
6,099.7
1,772.5
-21.0
2011
5,401.7
1,520.5
-252.0
2012
5,623.8
1,629.0
108.5
2013
5,715.9
1,592.0
-37.0
2014
4,815.0
1,457.9
-134.1
Source: Securities Industry and Financial Markets Association.
Further, beyond the more obvious potential impacts, we must also consider the possible impact of increased disclosure
for money market funds. While the revised disclosure requirements are not considered especially onerous or wrenching
for the money market fund industry, it will be the first time that investors will be able to clearly see the amount of liquidity
money market funds may be maintaining. Importantly, the money market fund industry will need to consider investor
responses to these new requirements. There will almost certainly be issues given the additional demand for short-term
assets and/or the potential for outflows when a fund begins to appear to be liquidity-challenged. Will investors opt to exit
a money market fund showing levels of liquidity below 30% in an effort to avoid the potential imposition of fees or gates?
Investors in aggregate may become wary of any developments that could materially reduce their ability to keep the entire
balance of their assets upon redemption and/or impair their ability to exit at their desired time.
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Conclusion
If a disruptive market environment should create
material outflows from money market funds, the
possible implementation of fees or gates could certainly
serve as an incentive for investors to flee the funds
much earlier than they normally might. Armed with the
knowledge that they could be hit with a fee or restricted
by a gate that could significantly delay their exit, investors may opt to redeem sooner rather than later if they
observe that liquidity at the fund level is close to being
compromised. No one wants to be the last one out.
In other words, the conditions set up by fee and gate
structures could themselves precipitate the situation
the SEC was attempting to avoid in the first place: a
“run” on money market funds and the downstream pull
back of money market funds from the CP market. This is
a long-standing industry criticism of the SEC’s solution.
In working to obviate the potential for massive redemptions from money market funds, the changes by the SEC
to Rule 2a-7 have effectively steered more demand to
the U.S. Treasury bill market and potentially increased
the pace of redemptions from money market funds as
investors may be inclined to exit before fees and gates
are imposed. The greater demand for and reduced
supply of Treasury bills is likely to suppress yields in
the short end. Accelerating the pace of redemptions
merely increases the probability of imposing fees and
gates on investors. These dynamics could materially
impact liquidity in important market segments like the
CP market, which continues to be an important funding
mechanism for companies. It remains to be seen how
money market funds will react to extreme environments
under the new regulation, but by all appearances, it
could be highly challenging for investors and investment funds.
If accelerated redemptions do occur, there will likely
be other active market disruptions amid a serious riskoff environment. Significant market dislocation will push
the limits of broader market liquidity, which already has
materially changed over the past five years due to financial regulation and reform. In general, market strategists
are concerned that the money market fund reform
measures may have created a situation in which there is
greater market sensitivity to potential liquidity events
and a greater chance of market seizure.
Endnotes
1BNP Paribas ABS Euribor Fund, BNP Paribas ABS Eonia Fund, and
Parvest Dynamic ABS Fund.
Footnotes
1. Marcin Kacperczyk and Philipp Schnabl, “When
Safe Proved Risky: Commercial Paper during the
Financial Crisis of 2007–2009,” vol. 24 number 1,
Winter 2010, Journal of Economic Perspectives, 29.
2. Kacperczyk and Schnabl, 30.
3. Kacperczyk and Schnabl, 30.
7
MARCH 2015 | Money market reform and the short end of the bond market
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