The impact of impending regulatory reform in the multi-trillion-dollar money market industry appears to be accelerating in short-term bond markets. The October 14th regulatory implementation date is leading to substantial outflows from prime and, perhaps unintentionally, tax-exempt money market funds, but the new rules also provide one of the few clear opportunities for investors.
In a nutshell, the new rules require a floating net asset value for institutional prime and tax-exempt money market funds, as opposed to the current tradition of setting the share price at $1. The rules were adopted in part to help reduce the risk of runs on money market funds, such as that experienced by the Reserve Primary Fund, which “broke the buck” in 2008 in the midst of the financial crisis. Though long in the making and well understood by financial markets, the impending implementation of these money market reform measures hold significance not only directly for investors in money funds, but due to the importance of the financing provided by these funds, across the financial market landscape.
The summer exodus
As money fund reform approaches, uncertainty over how much in assets will leave prime money funds forces managers to dramatically shorten the maturity of their assets—effectively dropping the supply of short-term financing. The outflows from prime money funds accelerated significantly in August and September, with outflows of $405 billion, bringing the total year-to-date exodus from prime to $699 billion, for a decline of around 54% so far for the year (source: ICI).
The effect has been a notable rise in the shortest maturity interest rates—even as rates in other parts of the world are heading lower, or even further negative. The acceleration in outflows as well made its way into tax-exempt money funds. While the focus of money fund reform was on institutional prime money funds, the reforms impacted the tax-exempt space by imposing redemption fees and gates. One unintended consequence removed the ability of these funds to provide “sweep” functionality and that impact exacerbated the shift out of tax-exempt money funds, especially in August and September. See the chart below.
The acceleration of outflows from tax-exempt money funds hit short-term muni financing rates in recent months. The SIFMA Municipal Swap Index rate (an index of 7-day average maturity) spiked significantly from 44 basis points to 87 basis points as of October 5. The increases on the very short end of the curve led shorter maturity muni rates to underperform and, remarkably, the very front end of the curve in municipals inverted, with one-year maturity muni averages lower than the SIFMA Index.
A tactical opportunity
The impact of money fund reform represents a unique and clearly regulatory-induced outcome. We see these increases in short-term rates at odds with the “lower for longer” and even negative rate bond world. As reform implementation passes, so too should the uncertainties associated with it, bringing supply back into the very front end of the curve. Heading into October, the widening in shortened municipals (and LIBOR rates as well) represents a tactical opportunity for fixed income investors to pick up some yield—albeit over a short investment horizon—for their cash that otherwise might get nothing, or worse.