- Looming money market reforms are expected to affect investment decisions.
- Investors worldwide move out along the yield curve and down in credit as they continue to search for yield.
- This one-two punch has spurred growth in ultra-short duration strategies.
Investors, who have grown increasingly wary of impending money market reforms and historically low yields, are pumping assets into higher-yielding investments at an ever-faster rate. According to Morningstar data, in the last three years the Ultra Short and Short Bond categories have grown 80% and 53%, respectively, while the Money Market category modestly declined 0.50%.1
“For money market investors, earning near-zero yields translates into a negative real, inflation-adjusted return, which we view as a really expensive insurance policy,” said Peter Yi, CFA, Director of Short-Duration Fixed Income at Northern Trust. “This has motivated many money market investors to reconsider their risk and return objectives, which many have found to be more consistent with an ultra-short fixed income strategy.”
Meanwhile, with the prospect of rising interest rates looming in the near- to medium-term, many core fixed-income investors have moved down the yield curve from core fixed income to ultra-short and short duration, trading some yield potential in return for shorter durations and reduced exposure to duration risk. “Institutional clients have been asking more about and investing in Ultra Short and Short Duration strategies,” said Scott Warner, Director of Fixed Income Product Management at Northern Trust. “We’re also seeing increased interest within the consultant community as they seek solutions for their corporate, foundation, and endowment clients.”
While many cash and fixed income investors will point to market dynamics as a key factor driving their interest in ultra-short and short duration investments, the impact of regulatory change should not be overlooked.
“Regulators have directed financial market reform efforts toward the money market industry and have pushed for more dramatic structural changes,” Yi said. “The overarching policy goal is to prevent a run on money market funds in times of stress, which could threaten the stability of the entire financial system.”
While U.S. regulators appear likely to make certain exemptions for government funds and retail investors, reform efforts for institutional prime funds are likely to surround the following requirements:
- Money market funds shift from a constant net asset value (NAV) to a floating, or variable, NAV.
- The adoption of redemption gates and/or liquidity gates in times of financial market stress. (Such redemption restrictions are intended to help avert the systemic stress that could arise in the event of panic selling in a volatile market.)
- A combination of both variable NAV and redemption and/or liquidity gates.
The Securities and Exchange Commission (SEC) hasn’t issued any formal guidance on when it will issue its final ruling, but one is expected in the coming months. There is plenty of uncertainty on what the final rule will include and the impact any changes would have on the money market industry. Regardless, the landscape will change significantly in the future.
“We expect increased demand for government securities as a result of a potential shift from broad-sector prime money market funds to government money market funds,” Yi said. “Additional demand could drive yields even lower on short-term government securities.”
Those lower yields on the safest money market funds could lead to even more demand for higher yielding ultra-short and short duration strategies, which stand just outside the purview of the money market industry, while still providing investors with high-quality low-risk investments.
However, Yi believes regulatory changes within the money market industry could lead to new market innovations. “It is possible that a new part of the market gets defined,” he said. “It might not be as aggressive as ultra-short fixed income, but it might not be as conservative as today’s registered money market funds.”
Cash Will Not Disappear
Even with possible changes to money market regulations that could reshape the industry, highly liquid cash products are in demand and will continue to exist.
The Big Picture: Money Market Products and Strategies Will Adapt
No matter what happens to the U.S. money market industry as a result of regulatory change, Northern Trust is confident that there will always be a need for money market products and investment strategies.
“We believe that whatever regulatory changes are introduced, they will most likely make the industry stronger and more stable,” Yi said. “After all, liquidity is valued in every market cycle. In general, shifting money out of money market funds or similar cash substitutes is a high-risk play, from our perspective. If you value principal preservation and liquidity, which are the defining characteristics of a money market fund, then moving into other asset classes could be dangerous if done as a knee-jerk reaction to possible changes.”
That said, the opportunity cost remains high for these products in light of the current rate environment and with the expectation of a lower-for-longer Federal Reserve interest rate policy. When developing a comprehensive cash strategy, one that moves beyond just money market products, it’s crucial that institutional investors work with an asset manager with sufficient scale and expertise. That manager should be one who can identify and deliver money market, ultra-short and short-duration solutions to meet their unique needs.
1 Morningstar Direct, as of March 31, 2014