July 2014 Monthly Commentary

Continued improvement in the economy and the realization that interest rates may rise sooner than expected resulted in a mild upward drift in interest rates in July as trading volume slowed.

The headline news during the month was that after nearly two years of wrangling and resistance, the Securities and Exchange Commission on July 23rd changed the operational rules for money market funds.  The next day the Wall Street Journal reported that “U.S. regulators approved rules intended to prevent a repeat of an investor exodus out of money market funds during the financial crisis.”  We think that the rule change does the exact opposite and is likely to worsen an exodus, and perhaps even before the next crisis.  The significant change, at least initially, is that Institutional money market funds will no longer be allowed to maintain a stable NAV and will, instead, be required to allow the NAV to float.  In addition, all fund companies, individual as well as institutional, will be allowed to temporarily block investor redemptions and impose a redemption fee of as much as 2% in the event of a mass exodus, defined as 10% outflow over the course of one week.  Money market funds that invest in only U.S. Government debt will be required to hold at least 99.5% of their assets in government paper, that’s an increase from the current minimum of 80% and will not be subject to the redemption suspension or fee.  That is, however, unless the fund board decides otherwise.  If so, then those funds may also impose a gate.

Institutional money market funds are the default solution for Corporations, Endowments, Retirement Funds, and virtually every other entity having cash on hand.  Because the NAV doesn’t float and the cash can be redeemed or invested on a daily basis, the funds are considered cash.  However, if there’s a possibility that investors may not be able to access the cash when needed, it no longer meets that definition.  Moreover, should the fund management decide to charge a 2% redemption, that would result in a material loss on cash that would impact earnings and need to be reflected on a corporation’s financial statement.  Because of that risk, corporate treasurers and chief investment officers are likely to shed Prime money market funds en masse.

The likely alternative to prime funds would be government money market funds.  In the massive, liquid Treasury Bill and Note market, such a gate is not likely to be needed.  However, simply the possibility of an exodus may be enough to discourage investors from using government funds.  Especially when just two years ago, Congress threatened to default on maturing Treasury notes.  While they avoided default, had they not, it’s likely that we’d have seen a mass exodus out of Treasury paper and a flight from government money market funds.

The catalyst for the change is the fact that despite the presumption of being safe, stable investments, money market funds are not very well managed.  Based upon SEC rule 2a-7, which is the standard for all money market funds, the funds are allowed to hold up to 5% of a single issue and up to 10% exposure to a single guarantor, an intolerably high level of concentration for a fixed income portfolio.  In an attempt to understand the riskiness of the money market funds, we analyzed one of the largest, “household name” fund and were shocked by its composition.  The top 10 holdings of the fund totaled 49% of the portfolio, with 15% of the fund invested in Japanese banks (including 7.1% invested in Sumitomo Mitsui Bank alone), 20% invested in 10 different European banks, and 10% invested in Canadian and Australian banks.  When the next financial crisis hits, it’s entirely possible that the 20% allocation to European banks sag in price.  Similarly, should the Japanese stimulus program fail and bank defaults rise, the large Sumitomo position may impact the fund negatively.  That, and any number of possible scenarios, is likely to test the resolve of the fund management to maintain liquidity and resist the temptation to impose a 2% redemption fee.

While certainly biased, we think the Halyard Reserve Cash Management (RCM) strategy is a preferable alternative, both in structure and riskiness.  As the RCM is a separate account held in the client’s name it would never be subject to a gate or a redemption fee.  That point alone makes the strategy far superior to a money market fund.  Secondly the diversification cap of 3% per name significantly lowers the riskiness of the portfolio.  Finally, the strategy is fully customizable and fully transparent. In our opinion, the RCM strategy is a safer, more liquid alternative to a money market fund.