In our last article, we discussed the changing structure of liquidity products available to investors. Now, we will revisit the topic and take a look at events that could potentially impact the short-term investment markets over the next 12 to 18 months.
The first event will most likely be the highly anticipated change to the Fed Funds target rate. After over 5 years of zero interest-rate policy (ZIRP), we appear to be on the precipice of rate normalization. Before the end of 2015, cash investors might see non-zero Treasury bill yields as the Federal Reserve moves away from the current ‘emergency’ funds rate. The creation, testing and implementation of the Federal Reserve’s fixed-rate, full-allotment overnight reverse repo facility (RRP), should allow the Federal Reserve to put a floor under rates while the interest on excess reserves (IOER) would create the rate ceiling. This change is probably as eagerly awaited by money fund managers who have been rebating fees to hold the buck, as it has been by investors looking for measurable interest income.
The second event we will experience is the implementation of the SEC’s reforms to institutional prime money market funds in the middle of 2016. This change deserves an asterisk as it is unclear as to what impact it will have on the market. The concern is that with the move to a floating NAV and the potential to impose gates and redemption fees, current prime money fund investors will move toward government funds due to their stable NAV and lack of potential restrictions. In addition, some institutions may not want to deal with transacting on fluctuating NAVs. History has shown that there is potential for a tremendous amount of inertia or complacency from liquidity investors as previous changes to money funds and deposit insurance have barely elicited a collective yawn from market participants. However, if the seemingly punitive risks and operational headaches in prime funds are enough to drive significant flows to government funds, there could be a widening of short-term credit spreads, creating excess demand for government paper, hence the importance of the tested and properly functioning RRP to keep a floor on rates. It is important to note that none of this is lost on the top-tier prime fund investment managers; portfolio managers are well aware of the risks and have been preparing their portfolios accordingly.
It’s important to consider the impact that banks and corporations will have on liquidity management going forward. Faced with increased regulation and more stringent oversight, banks are increasingly unwilling to keep large deposits on their balance sheets due to rising capital charges. The implication here is that there are lots of liquidity assets all dressed up…with nowhere to go.
Corporations, particularly technology companies, hold tremendous amounts of cash and short-term investments on their balance sheets. At the end of 2014, it was estimated that non-financial corporations were holding almost $2 trillion in cash. A recent Bloomberg article reported that corporate balance sheet investors are now a serious force competing for new, shorter-term corporate bond issuance with the top tech companies accounting for an estimated $500 billion in cash. Some of these assets are offshore, waiting for tax relief to be repatriated. Nonetheless, large corporations have a significant market presence; they are not solely money market fund investors, but rather direct investors in the short-term bond markets and they are competing with traditional asset management firms. So far, their presence has been a positive one, providing another source of demand for shorter maturity bonds. However, going forward, it will be important to monitor the impact of large corporate investors as they could provide a backstop if prime money funds see substantial redemptions, or compound the problem if their redemptions overlap with traditional liquidity investors.
Keeping on the topic of corporations, one of the other changes in the marketplace has been the substantial reduction in short-term funding by corporations. Painful lessons learned during the great financial crisis of 2007 and 2008, coupled with exceedingly low bond yields, have led corporations to term out their debt and reduce their reliance on commercial paper funding. If you were to look at the holdings of the average prime fund today, you would find that they are dominated by foreign financial institutions which have historically relied on wholesale funding. You would be hard-pressed to find a U.S. industrial issuer. Formerly, many blue chip U.S. corporations and federal agencies were large and active issuers in the commercial paper market, but the likes of GE, General Motors, Ford, Sears and other recognizable names have either disappeared or substantially diminished their presence in the market.
Finally, liquidity in the fixed income markets has become a prominent concern for investors. Heightened regulations have driven the ever-shrinking ranks of broker-dealers to reduce capital allocated to market-making activities. Emblematic of this, the number of primary dealers has fallen by over 50% since the late 1980’s, and now sits at 22 members. The concern here is that as the number of dealers has dropped, the fixed income markets have continued to expand, and the exit door, as represented by the broker-dealer community, is much smaller, posing another potential hazard to liquidity investors.
What does this mean for liquidity investors? On the positive front, a Federal Reserve on the normalization path should offer investors a slowly increasing yield on their liquidity assets. On the more cautious front, regulations and changing market dynamics have created the potential for both risk and opportunity for investors. Market liquidity has been a substantial concern for the past few years, made even more prominent with the recent ‘taper tantrum’ experience.
As these liquidity events approach over the next 12 to 18 months, there will be little to no margin for error. Patience and conservatism will be virtues in a world of near-return-free risk, especially given the relatively short timeframe needed for some major developments to play out. We will continue to monitor the environment closely and react accordingly, keeping the principles of safety, liquidity and return front and center.