Blame it on Regulation Q.
Within the Glass-Steagall Act of 1933, Regulation Q used to impose a cap on the interest rates banks could pay on deposits. Over time, investors
sought a better liquidity management solution and higher returns for their excess liquidity. Eventually, innovation took hold, and the regulated
2a-7 U.S. money market fund industry began to germinate in the 1970s, offering a balance of higher returns, $1 par share price and same-day
Just as the emergence of money market funds more than four decades ago encouraged investors to consider a different approach to liquidity management,
the SEC’s new money market fund regulations, which take effect in mid-October, should also mark a point of reflection for investors. We would encourage
investors to consider the impact of these alterations, including the deteriorating purchasing power protection of money funds. We would also encourage
those still allocated to money market funds (hopefully to a lesser degree), to look “under the hood” at the composition of fund holdings. At a glance,
investors can see that all money market funds are not equal. Substantive differences in holdings can result in differences in net returns to investors
over time, even though each of these funds is adhering to the same SEC regulatory requirements.
What to consider in money market funds
In an attempt to safeguard money market funds and remove previous structural deficiencies, the SEC regulations have refined what investments these
funds can make. Government money market funds, which can still offer investors the stability of a fixed $1/share net asset value, now need to hold
99.5% of assets in government-related securities – namely, Treasury bills, agency discount notes and repurchase agreements, or repos. As with other
core fixed income strategies, these funds’ largest risk will now be interest rate risk.
To successfully navigate this risk, asset managers need to have a robust investment process to analyze their expectations for interest rates/monetary
policy against what is priced into the market, as well as compelling views on global macroeconomic trends. Without these, an investment manager will
likely leave valuable basis points of income on the table.
Another consideration for investors should be the size and scope of the investment manager’s capabilities. The skillset, expertise (even beyond money
markets) and size of the manager should be focal points rather than the size of the fund itself. Firm size can mean greater access to the repo market
in particular, and repos will be a precious commodity: They have historically offered higher yields than short-dated Treasury bills and agency discount
notes, and the yield differential between overnight repos and three-month T-bills is currently at its widest in years (see Figure 1).
Moreover, different types of repurchase agreements can potentially yield even more: Delivery-versus-payment (DVP) repos, which PIMCO generally favors,
have historically offered superior returns and collateral protection for investors compared to the tri-party custodian alternative, which the majority
of larger money market fund complexes employ. Thus, money-fund managers that have greater access to (DVP) repo balance sheet can potentially earn
In addition, as banks continue to reduce their footprint in the repo market due to increased capital requirements, the aggregate amount of repos
outstanding has decreased by more than $2.5 trillion since 2008. The remaining market participants are increasingly deciding with whom and how much to
trade based on several factors, including relationship size – not fund size. Asset managers who engage repo providers on both sides of the “balance
sheet” – i.e., both lend cash and borrow cash ‒ will be able to better negotiate rates for clients, as they can diversify their exposures and limit
them to those offering the best levels. In essence, most money market funds are price-takers, accepting whatever rate is offered by financial
intermediaries due to limited negotiating power. In contrast, larger asset managers with broader scope in the global markets have the potential to
garner more repo allocations and thus higher yields.
Finally, how a fund is managed is more important than ever. Actively managed funds can take advantage of opportunities for higher yields as they arise,
without the constraints of mirroring their benchmarks, which passive strategies typically do. As a result, they may be better able to preserve
investors’ purchasing power in the low interest rate environment, where every basis point counts.
PIMCO’s actively managed Government Money Market Fund produced a net yield of 0.33% versus 0.17% for the government money market fund universe, based
on Crane’s Government Institutional MF Index, as of 30 September 2016.
Looking closely at short-term liquidity allocations
With the upcoming implementation in October of money market reform measures as mandated by the SEC, PIMCO encourages investors to also review the
composition of their liquidity strategy ‒ both in terms of risks, given the new regulatory framework, and opportunities to earn more income, given the
altered structural landscape. Because money market funds offering $1 NAVs will have limited options for increasing yield under the new regulations, we
continue to advocate a “three-tier” approach to liquidity management.
For the first tier – immediate liquidity needs – money market funds are well suited. The second and third tiers, for holdings of more than three
months, can then be invested in short-term liquidity alternatives that aim for higher yields with more diversified risk profiles. This framework not
only utilizes same-day traditional liquidity vehicles like money market funds but also employs actively managed short-term and low-duration bond
strategies in an effort to maximize yield and actively navigate changing liquidity conditions in the broader marketplace.