Fitch: Money fund reform to alter short-term market supply/demand dynamics

Asset managers are repositioning their cash management platforms in response to money fund reform, but investors are likely to take time to adjust to new features mandated for prime money market funds, Fitch Ratings says. Yields on different liquidity products have converged in the low interest rate environment in the US, but spread differentials among these offerings will become more pronounced as rates rise and as short-term markets evolve.

Six months after the SEC voted on reforms, money fund managers are beginning to take steps to comply with the new rules and position to retain and attract clients. Fidelity, the largest US money fund manager, announced that it will convert more than a quarter of its prime fund assets into government funds recently, as investors indicated unease over new features mandated for prime funds. Federated, the fourth largest manager, also announced an overhaul of its business and a slew of new liquidity products. Other fund managers are working on similar moves, and new product offerings may include ultra-short bond funds, private unregistered money funds, separately managed accounts, and money funds that maintain maturities under 60 days to preserve a stable net asset value (NAV).

The changes in the cash management industry are set to upend the supply and demand dynamics in the short-term markets. The greatest benefit appears to accrue to government securities, which will likely see higher demand at the expense of corporate and bank debt as some prime money fund assets shift to government funds. Government money funds largely retain the characteristics that investors value in money funds, such as a stable NAV and unfettered access to liquidity.

Wider spreads between yields of prime and government funds, as well as other products, may lead investors to reconsider their investment choices. According to iMoneyNet data, the current weighted average spread between prime and government money fund yields is only 0.04%, making the opportunity cost of switching from prime to a government fund relatively low. Higher demand for government securities would push down the returns on these investments, and in turn the yields of the money funds that buy them. This could widen the spread between prime and government money funds.

Extremely low yields on money market securities have led many money fund managers to subsidize their funds to maintain a positive yield, and the resulting spreads between prime and government funds are unnaturally compressed. As interest rates rise closer to historical levels, spreads between prime and government fund yields should expand. Spreads could move closer to, or even higher, than the 0.14% average between January 1995 and April 2007, a more 'normal' interest rate environment.