When we hear the U.S. Federal Reserve may begin to “normalize policy,” we should not expect things to return to normal in the money markets. A decade ago, normal meant money market investors enjoyed relatively high rates in the fixed income spectrum, investment managers had a plethora of high quality issuers in which to invest, collateral was abundant for both borrowing and lending, and most importantly, savers actually earned competitive, market rates for their temporary and excess cash.
None of these things holds true in the money markets today thanks to sweeping regulatory change, and the investment landscape for conservative investors is not going to change simply because the Fed begins to raise its overnight rate. Today, investors who seek these positive attributes of the past need to look at more than just money market funds to enhance their portfolio liquidity, income and stability.
Things can and do change permanently, and that is exactly what has happened since 2008 thanks to regulatory action. Regulation has caused permanent transformation in the liquidity food chain—investors, debt issuers, broker/dealers and the banks—because of new sets of rules (i.e., SEC money market reform, Dodd-Frank, Basel III, etc.). These new rules create a gigantic mismatch between where investors who want liquidity are forced to invest (demand) and where issuers are forced to issue (supply). The result is that the shorter and more conservatively you invest, the more you are penalized in terms of the rate you can earn than you otherwise would have been. Additionally, there are other consequences of these regulations that have to be addressed from a risk perspective, such as the concentration risk in similar securities and other “unintended” consequences, such as dislocations in the short-term funding markets.
Regulatory Fallout Has Impacted Yields
A good example of the regulatory fallout can be seen in the money market fund space, where funds are already required to hold 30% of their assets in securities that mature within five business days. There has been a noticeable drag on fund yields as a result. Typical non-government money market funds used to approximate one-month LIBOR yields on a net basis. The current LIBOR rate is just 0.20%,1 and most money market yields are well below that.
In addition, the new rules potentially impose gates and fees if funds’ five business day liquidity levels fall below certain thresholds, although these rules don’t apply to government money market funds. As a result, the marginal demand for the government product is higher while the supply of these securities, in particular repurchase agreements used to fund broker/dealer balance sheets, has fallen. Even in the non-government space, issuance in traditional short-term investments, such as bank CDs and commercial paper, has not kept up with demand for liquidity.
Another good example is the current situation with U.S. Treasury bills. Some short-term Treasuries offer negative rates of return for maturities. This means investors are willing to pay the U.S. Treasury to borrow from them! The supply of bills as a percent of the Treasury’s debt portfolio is at a 20-year low, as they look to both extend their own maturities in this low rate environment and pay down less costly short-term debt ahead of annual debt-ceiling limits. While it is possible that the supply of Treasury bills may increase to coincide with the spike in demand that is expected to come next year with the implementation of further money market reforms, that supply increase will likely only meet the incremental demand and not solve the overall supply-demand imbalance that exists now. Part of the problem is that the regulations tend to force investors into short-term government securities to begin with, and these securities, while liquid, tend to be among the most volatile securities. Anybody remember what happened to these securities during the last government shutdown?
A Possible Alternative for Conservative Investors
The bottom line is that investors needn’t accept the regulators’ Faustian bargain in their search for conservative income—to accept undue credit quality and volatility, or receive very little for your risks in a government portfolio. Fortunately, more balanced supply/demand characteristics exist just outside the regulated money market space, in the part of the yield curve where issuers are incentivized to issue debt, with far better non-government diversification and income capability.
At OppenheimerFunds, we have two low duration funds that have benefitted from this regulatory mishmash—the Ultra-Short Duration Fund and the Limited-Term Bond Fund. Given their duration profiles, these funds may mitigate for investors some of the volatility inherent in Treasury interest rate moves, while still offering the potential for investors to realize an increased income stream if the Fed actually does raise rates.
“Normal” is a relative term and is best viewed with a lens that doesn’t go too far back, certainly not prior to the financial crises in 2008. The evolution of products in response to a changed regulatory landscape is a natural part of the markets, and at every inflection point there are opportunities for investors to change right along with it.
1 www.global-rates.com, as of 9/29/15.
The London Interbank Offered Bank Rate (LIBOR) is the interest rate that banks charge each other for loans (usually in Eurodollars). LIBOR is officially fixed once a day by a small group of large London banks, but the rate changes throughout the day.↩
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