Mending the buck
Martin Steward asks how investors might analyse money market funds after last year’s shock to the system
Some point to money market funds breaking the buck as the high water mark of the financial crisis. Only one had ever ‘broken the buck’ before - ie, failed to maintain its stable $/€/£1.00 NAV share price: the Community Bankers US Government Fund paid out 96 cents in 1994. But on 16 September 2008, the venerable Reserve Primary Fund’s NAV tumbled to 97 cents after writing off $600m of Lehman Brothers debt - sparking a liquidity crunch and a wave of redemptions that put dozens of funds underwater.
In response, the Securities and Exchange Commission (SEC) has proposed that money market funds - defined under Rule 2a7 of the Investment Act 1940 - should keep a minimum in ultra-liquid securities; set their maximum weighted average maturity (WAM) at 60 days; and be able to suspend redemptions. The Institutional Money Market Funds Association (IMMFA) is pursuing similar aims, and defining money market funds to exclude some of Europe’s ‘enhanced’ or ‘dynamic’ short-dated credit funds.
“A lot of what we are doing is taking current best practice and enshrining it in the Code,” says IMMFA CEO Gail Le Coz.
All 2a7 and IMMFA funds maintain stable or constant NAV. The SEC is consulting on whether 2a7 funds should move to variable NAV. SEC Commissioner Troy Paredes is among those who worry that, should this “shadow NAV” fall below constant NAV (CNAV), investors might rush to redeem. “We had one member leave which converted its funds to VNAV [variable NAV],” says IMMFA’s secretary general Nathan Douglas. “Everyone else has reiterated their commitment to CNAV. It’s easy from a daily operational and accounting perspective.”
But some, such as Duncan Thomson, investment director for money market funds at SWIP, suggest that VNAV helps to manage price volatility and that “trying desperately to maintain stable-NAV has caused a lot of the recent problems”. Others question whether CNAV encourages investors to think of these as guaranteed banking products - in the US some funds even come with chequebooks. No 2a7 or IMMFA fund sponsors have made formal guarantees, but when the crisis hit, many did step in to shore-up broken CNAVs; Moody’s and Fitch are proposing to evaluate sponsor strength; and the G30 has suggested that only banks should run CNAV funds.
Aviva Investors is that one IMMFA member that broke away from CNAV. “I think we’re being more honest,” says head of liquidity business development Colin Cookson. “If a sponsor genuinely wants to stand behind their funds they should issue a guarantee.”
Quite apart from the pressure it might place on providers - “Do you want to be in a business that earns you 10bps but might one day require you to put up £400m?” as Tom Meade of Royal London Cash Management puts it - investors might assume sponsors will bear their risk and therefore neglect due diligence again. “Looking at parental strength is missing the point,” warns Chris Oulton, CEO, Prime Rate Capital Management. “The real point is portfolio construction.”
Institutional buyers are no longer fixated on yields, ratings and size, and greater concern over security has meant looking deeper into portfolios. But some are going from a point at which, in the words of Michael Sullivan at Investec, they “weren’t even aware of the guidelines of funds they’d bought”, to comparing subtle differences between 150-200 line portfolios. “Investors are now asking for line-by-line transparency,” says Brian Jack, head of liquidity funds at Ignis Asset Management. “Whether they are actually able to analyse that is another question.”
Are any portfolio-level metrics sufficient indicators of the duration, liquidity and credit risks embedded in these funds? WAM is good on duration but not as good an indicator of liquidity as one might expect, particularly if an aggressive portfolio is being managed to meet a WAM limit. Some funds implemented barbell strategies by putting 40% in floating rate notes (FRNs) with WAMs of 360 days or more, while bringing portfolio WAM down by piling 50% into overnight rates. That’s fine until a block of clients wants their money: the fund can liquidate overnight positions but the remaining FRNs would blow the fund’s 60-day WAM limit.
“Investors are going to ask for access to their money,” notes Tony Andrews, money market funds manager at Henderson Global Investors. “Unfortunately, some managers forgot that.”
The SEC and IMMFA are looking at establishing minimum liquidity buckets - 10% in overnights and 30% in one-week maturities at the SEC, 5% and 20% at IMMFA. Just as important are the ways client-relationship teams model, manage and stress-test cashflows. The more diverse the client base the easier this becomes, and the greater the freedom of the manager to drive performance with interest-rate views.
“We did some attribution analysis on what performance would be if we got cashflow and duration calls correct, and we found that both added 4bps,” says Kathleen Hughes, head of global liquidity EMEA at JPMorgan. “We realised that we were never going to get the interest-rate calls perfectly right, so it made a lot of sense to maintain very close client relationships.”
WAM paints an even more misleading picture of credit spread duration, which became crucial after managers loaded up on tranches of long-dated floating-rate ABS that were incredibly liquid and traded with spreads as tight as the banks issuing them - until the Bear Stearns incident in 2007. “The carry trade long credit works until it blows up,” says Daniela Meier, a senior portfolio manager running France, Luxemburg and Dublin-domiciled funds for Fortis Investments.
WAM opens the loophole for this arbitrage by taking interest-rate reset dates as a security’s date of maturity. That means 720-day FRNs have 30-day ‘maturities’ because their rates reset monthly. Ratings agencies are proposing to complement WAM with weighted average days to final (WAMF) or weighted average life (WAL) metrics, and the SEC and IMMFA propose a WAMF/WAL limit of 120 or 90 days. Using both measures together can help establish how much of a fund’s extra yield is credit spread risk.
“Applying WAL to our funds puts up our WAM by four to five days,” says Mark Camp, Henderson’s director of institutional liquidity funds. In general, that is what an investor should expect from a classic 2a7 or IMMFA fund; an ‘enhanced’-type fund might be expected to see WAMF/WAL add two to three months, while it might add a year or more to a ‘dynamic’ fund.
Why did credit duration creep inexorably upwards? There was, as Meade says, “mission creep over the easy years”. Money market funds conceived to diversify cash exposure were used for the alchemical transmogrification of seven-day LIBID into three-month LIBOR.
“Up until August 2007, pretty much every client was looking for LIBOR+50bps,” recalls Robin Creswell, managing principal at Payden & Rygel. “The pension funds pushed hardest because they were hoping to plug deficits. They wanted same-day liquidity, capital security, enhanced return. Now we have to tell them that those three requirements are mutually exclusive.”
Right now, of course, it is a doddle for pension funds to use money market funds playing only the duration curve (with no credit risk) to collateralise LDI swaps: rates have been falling and the yield curve is nice and steep. But once that curve normalises, will investors have to accept that credit risk is the only solution?
Alongside its CNAV IMMFA fund, Henderson’s AAA-rated VNAV Cash Fund uses “old fashioned” duration management to target three-month LIBID, settling at T+1; but “getting three-month LIBOR-plus without security or liquidity or credit risk is a non-starter”. Similarly, Thomson at SWIP says that “the liquidity fund which we set up especially for LDI does have to start taking on some form of credit risk”; and Meier says that Fortis’s LDI mandates employ swaps and interest-rate overlays and some credit risk. “A lot of this is about investor communication,” she says. “If you have a three-month Euribor-plus target, let your investors know what sort of volatility they can expect to achieve that return.”
There is room for all the types of vehicles that have been called ‘money market funds’ in the past - but investors need to work harder on matching the right ones with their requirements. The more rigorous definitions emerging from IMMFA will help; asking for liquidity-bucket and ratings breakdowns and WAMF/WAL portfolio analyses should offer a more granular - but practical - indication of the risks being taken.