Money market funds are on the verge of major change. With the implementation of new U.S. Securities and Exchange Commission rules scheduled for October 14, institutional prime and tax-exempt funds will go from constant-dollar to variable net asset value (VNAV) — share prices that float with the market — while all prime funds will be required to adopt liquidity fees and redemption gates.
The SEC reforms are intended to address structural risks in money market funds. The adoption of VNAV by some funds would be the most dramatic change from the status quo, as the constant-dollar NAV has been an essential feature of money market funds throughout their four-decade history. Indeed, many fund managers are busy converting money market funds from prime to government strategies ahead of the rule changes. Funds representing a total of $345 billion in assets will undergo that conversion, because funds that invest primarily in government securities will not be subject to the new rules.
It’s not just VNAV that is driving the change. In the conversations we at Northern Trust Asset Management have had with investors, the most urgent concern for many clients is the potential for liquidity to be constrained by redemption gates or fees, which may kick in during times of market stress. These investors can handle a slight fluctuation in their principal caused by a VNAV, as long as they can get their cash back when they need it. “Any cash is better than no cash,” a large corporate client told me. If liquidity is trapped, he explained, the knock-on effect to the business will be much more severe than the variance in principal from slight changes in the NAV.
The move to government funds may be a knee-jerk reaction, but it makes sense — to the extent that investors in this low-rate environment simply don’t see themselves being compensated for the complexities of a VNAV or even the slightest probability of being gated in their fund. But as assets flood the market for government securities, driving yields even lower, we urge large investors to consider cash management strategies that will mitigate the impact of low yields while providing for liquidity needs.
A cash segmentation strategy allows investors to achieve a better balance between risk and reward. The strategy relies on three buckets, each with its own distinct risk, return and liquidity characteristics:
Operational cash. For short-term spending needs in the next 30 days, assets should be held in a highly liquid investment, most likely a government money market fund.
Reserve cash. For intermediate or uncertain spending needs over the next 30 to 90 days, assets can be invested in money market funds or custom strategies seeking slightly more attractive yields, with a modest tolerance for principal fluctuation.
Strategic cash. Assets for long-term spending needs, six to 18 months away, require less liquidity and can target the highest possible yield while preserving principal. For this purpose, ultrashort funds offer high-quality short-duration exposure.
This segmentation framework is a more effective way of managing cash holistically. Many investors keep all of their cash in money market funds. With some fund types under scope of a gate or a VNAV, however, it may be best to move some funds into the reserve or strategic buckets. Within a cash segmentation strategy, the operational cash can act as a buffer, providing some protection for the allocation to the strategic cash bucket and allowing for higher yields without exposing investors to inappropriate levels of risk.
Cash management plays a critical role in a balanced asset allocation by providing liquidity and stability. Cash gives you the flexibility to be opportunistic in the marketplace while also protecting the principal for part of a portfolio. This stability can help offset the impact of volatility elsewhere, providing readily accessible cash that prevents the need to sell risk assets in the event of a liquidity crisis.
In our lower-for-longer interest rate environment, cash has been an expensive insurance policy. This situation will only intensify as investors crowd into low-yielding government funds to avoid the fees, gates and VNAVs to which other money market funds are subject under the new SEC rules. We believe new demand for government securities will keep Treasury yields grounded near zero, and we expect credit spreads to widen from that lower demand. We also believe all the prime and tax-exempt funds will focus on shorter, more liquid securities to ensure adequate buffers from the new liquidity requirements, so fund directors won’t even have to think about gating a fund.
With these market forces at work, now is an opportune time for investors to benefit from a cash segmentation strategy that includes access to daily liquidity and focuses on principal preservation with a competitive yield. We anticipate that there will be a segment of some investors who transition back into prime funds once they become comfortable with the new regulations and start searching for a higher return than a government money market fund can provide. One way for investors to navigate new changes is to adopt a cash segmentation strategy ahead of the October rule implementation deadline.
Peter Yi is director of short-duration fixed income at Northern Trust Asset Management in Chicago.
See Northern Trust Asset Management’s disclaimer.
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