Doing More with Less: Balancing Supply and Demand in an Evolving Money Market Landscape
A combination of a recovering U.S. economy, an active Federal Reserve and a more stringent regulatory environment has made the search for sufficient supply of investable securities as much a focus for money market funds as their ever-vigilant attention to credit quality. This situation requires a delicate balance as fund managers continue to adapt to what has been an increasingly supply challenged investment landscape.
“A historically low interest rate environment, of course, has magnified the issue when it comes to supply,” said Deborah Cunningham, chief investment officer for Federated’s global money markets. “But from a credit quality perspective, we are more confident than ever that the rigorous quality and maturity standards of Rule 2a-7 have strengthened the ability of funds to withstand market stresses.”
Given the interdependence of the economy, the investment community and the money markets, it’s widely anticipated that new securities in which fund managers can invest will be introduced, some as soon as 2014. This report provides an overview of the current environment among money market issuers from the perspective of the Federated money market managers and analysts who have been keeping a close watch on their sectors throughout these eventful times.
Having gone through an extensive reparation process, domestic banks are largely better capitalized and have better liquidity profiles than they have had in years. According to Mark Weiss, senior investment analyst in Federated’s taxable money market group, this doesn’t mean it’s clear sailing ahead, however. “Domestic banks are continuing to stabilize and asset quality is improving, at least in terms of the larger banks,” Weiss said. “This has allowed these banks to enhance bottom-line profitability through the release of loan loss reserves.” However, banks still face a number of revenue headwinds, including an extended low interest rate environment, a lack of loan demand from borrowers and regulatory changes. As a result, despite the enhanced bottom-line profitability, banks’ core earnings growth remains challenged. In response, they are focusing on cutting expenses and finding new ways to make up for lost fee revenue.
At the same time, a slow economy and political uncertainty are having an impact on the issuance of bank paper. “From a supply side, banks have been loosening lending standards, but at a relatively slow pace,” said Weiss. “And while companies are showing signs of increasing demand for loans, they remain hesitant to take on additional debt as they are unsure about future growth prospects in light of a sluggish economy and the ongoing mandate for U.S. fiscal discipline,” Weiss explained. As a result, although loans are growing again, the pace has been gradual. This has allowed many banks to continue to rely on core deposits for funding versus wholesale investments from money market funds.
Uncertainty regarding regulatory changes is another challenge. Basel III aims to establish international standards for bank capitalization and liquidity. With respect to capital, banks have a reasonable estimation of the new requirements and continue to make efforts to align themselves with the proposed rules. Although the Basel III phase-in period originally scheduled to begin in January 2013 has now been delayed, it will not be for long and the banks are opting to prepare sooner rather than later. Most of the larger banks are already in line with the higher capital standards. However, others continue to build capital and to divest non-core assets in order to bring ratios in line.
As for the new liquidity standards, a greater degree of uncertainty exists as regulators intend to monitor the potential impact of new proposals on the financial system and overall economy. “Of course for money funds, the 2a-7 requirements (which restrict money funds’ investments by quality, maturity and diversity) are somewhat at odds with what the new regulations are asking of banks,” explained Weiss. “On the other hand, anything that ensures that the banks have better liquidity profiles makes the issuance more safe and secure.” However, Basel III’s proposed liquidity ratios are weighted in a way that requires a bank’s funding to be longer dated while the 2a-7 rules call for money market funds to allocate a larger percentage of their holdings at the shorter end of the money market yield curve. As the regulatory rules become clear, Weiss believes that banks and money market funds will work together to develop capital market instruments that comply with 2a-7 rules while enabling banks to meet their liquidity requirement. “For now,” he noted, “it’s still a work in progress.”
For many money fund managers, certain international banks remain a viable investment option because they have been consistently active in their issuance while maintaining a sound credit profile. This is the case even as regulatory oversight has increased and repercussions from the sovereign debt crisis continue. Nonetheless, the overall situation outside of the U.S. is not as improved from an economic or credit perspective. According to Bill Jamison, senior investment analyst in Federated’s taxable money market group, the key is to both know what you own and balance that understanding against the current unsettled environment. “In addition to being extremely selective in terms of countries and issuers, we are taking an additional conservative stance by shortening the maturities of the foreign banks that we purchase. For example, instead of six-month securities, we may be buying one- or three-month securities,” he explained.
From a credit quality standpoint, there is still pressure around foreign banks. “The outlook remains one of caution as banks are maintained as a key functional area of the flowing economy. This will result in fund managers remaining diligent,” said Jamison. “Many fund managers will say that approving issuers is the easy part of the process. The real challenge begins once the issuer is approved and involves that constant, daily monitoring of an issuer’s quality. Eventually, Basel III will bring about new liquidity requirements and raise overall capital standards, and this looks to be a positive development for the credit profile of the banks globally.”
With overseas banks, disclosure has always been a consideration for fund managers given that European banks don’t have the same requirements, such as SEC filings, that have been mandated in the U.S. for years. This issue has become even more of a concern in the current environment. According to Jamison, the situation has improved somewhat over time and by thoroughly analyzing the information that is available, it is possible to make reasonable credit risk determinations.
The primary consideration when investing overseas is the sovereign’s quality. For this reason, funds have avoided banks from Italy and Spain as the sovereign debt crisis moved their way. Portuguese and Irish banks have long since been removed from this space. Even when the overall quality of a sovereign is established, as it has been for Australia, Germany and Sweden, Jamison noted, determining the credit quality of that country’s leading banks is an essential next step. These top echelon banks are typically global in nature with a range of operations well beyond their home countries. “Although this global scope requires an additional layer of risk management on the part of the banks,” said Jamison, “it offers the benefit of additional diversification of funding and earnings for these institutions and enhanced potential for issuance of investable securities.”
Asset-Backed Commercial Paper
One of the largest sources of money market fund issuance pre-financial crisis, the asset-backed commercial paper (ABCP) market has experienced substantial contraction over recent years. According to Mary Ellen Tesla, senior investment analyst in the taxable money market group at Federated, the market’s pre-crisis level of some $1.2 trillion in outstandings has diminished to approximately $300 billion. “Where money funds had invested 35% to 45% in ABCP, the average now is probably closer to 12%,” Tesla explained, a function of both decreased supply and pricing. Unlike single-issuer term asset-backed securities, most ABCP programs are administered by large financial institutions. An ABCP program can finance the assets of hundreds of sellers, including auto finance companies (auto loans and leases), manufacturers (trade receivables and equipment loans) and financial intermediaries (credit card receivables and student loans) through a conduit structure. The majority of ABCP programs are structured with 100% liquidity support as well as transaction-level and program-wide-level credit enhancement.
“The creation of ABCP is largely aligned to the state of the economy,” said Tesla. “With little evidence of a sharp upturn in the near future, the amount of ABCP is likely to remain at a lower level until the economy picks up and, along with that, demand for credit.”
Additional factors affecting the ABCP market—outside of the economy and interest rates—are consolidation and/or termination of conduits by program administrators, limited new product availability and finding good value among ABCP names versus other short-term product offerings. Regulatory uncertainty is also a factor affecting both asset-backed commercial paper and the term market. Tesla notes that despite the decrease in ABCP issuance, there is a silver lining. “The market is again dominated by straightforward, multi seller, bank-administered ABCP programs.”
Term Asset-Backed Securities
Because the primary types of term asset-backed securities (ABS) in which money market funds invest are auto and equipment loans, it’s not surprising that supply over the past few years had decreased in step with continuing economic stress. Term ABS consists of loans issued by finance companies or the finance company arm of a manufacturer—for example Ford Credit for Ford Motor Company have long been considered a creditworthy investment for money market funds because, in most cases, the funds buy the most senior tranche of a term ABS deal and, therefore, are first in line for repayment of principal and interest.
“The advantage of term ABS is that even if the issuing company is undergoing stress, consumers will continue to make their loan payments,” said Tesla. “Because the loans involved in term ABS are isolated from the corporation in a Special Purpose Entity, when consumers make payments, the cash is directed to paying off the term ABS investor rather than flowing into the corporation’s general account.” At the highpoint in 2005, auto and equipment term ABS issuance was at $125.7 billion. Increased auto sales driven by pent up demand, easier credit and low interest rates increased 2012 ABS to $108.7 billion. Many different types of investors found yield in the term ABS space, driving down yields and crowding out money market investors.
Securities from these sectors (representing pharmaceutical, chemical, health care, technology, consumer goods and retail companies, among others) currently make up a relatively small percentage of money market fund holdings. Nonetheless, they offer valuable portfolio diversification and, in many cases, a yield advantage. Short-term issuance remains light, however, as companies continue to maintain large cash holdings on their balance sheets. Also, as long-term interest rates continue to remain very low, companies are tending to issue debt at the longer-end of the maturity spectrum at very attractive rates.
According to Joe Natoli, senior analyst in Federated’s taxable money market group, commercial paper issuance remains light, the shortest debt remains expensive, but credit fundamentals at most companies are very solid. “Revenue growth remains tepid, but growth in net income continues to remain strong. Companies have adjusted to ongoing mediocre economic conditions by focusing on cost cutting and efficiencies,” he explained. “Much like the consumer, these companies are holding onto their cash and remaining cautious about large expenditures and their debt levels.”
A growing number of companies have issued debt to fund acquisitions and return capital to shareholders through dividends and share repurchases. “It’s a positive development from an issuance standpoint and we often take advantage of such opportunities,” said Natoli. “However, credit approvals and security purchases particularly in response to acquisitions and shareholder-friendly actions—are closely analyzed and weighed against any potential credit deterioration that may result.”
Of course, industrial, retail and issuer exposure from any other credit sector falls under tightened 2a-7 rules, particularly with regard to “Tier II” or lower-rated issuers. The percentage of Tier II security exposure that is allowed to be held in a fund is 3%. And just 0.5% of any single issuer can be invested in a single fund.
The current state of municipal issuance is one of continuing light supply, a reflection of fiscal uncertainty despite low borrowing costs. Municipal money market funds typically invest 60% to 80% of their total assets in variable rate demand notes (VRDNs), favored because they are highly liquid and backed by bank liquidity or letters of credit. Most bank facilities are now provided by a small number of U.S. banks. However, direct bank loans have gained market share, which has negatively affected the supply of VRDNs.
According to The Bond Buyer 2012 Yearbook, VRDN issuance declined from $50.3 billion in 2007, to $20.1billion in 2011, and further declined to $13.6 billion in 2012.* More specifically, VRDNs backed by bank letters of credit declined from $20.7 billion in 2007 to $12.5 billion in 2011, while VRDNs backed by bank liquidity declined from $17.7 billion in 2007 to just $1.7 billion in 2011. The decline in liquidity-backed VRDNs is partially a reflection of the demise of financial guarantors and the refinancing of the VRDNs that were initially backed by insurance and bank liquidity with other forms of debt.
Municipalities continue to issue short-term debt. In 2011 there was $60.1 billion in short-term note issuance, which represents a 7.5% decline from volumes seen in 2010, but supply remains healthy. In addition, according to a survey conducted recently by the National League of Cities, about 37% of cities plan to issue debt in 2013, up from 20% in 2011. Some of this issuance may start in the short-term market before being permanently financed with long-term bonds. There is concern that the increase in issuance may be negatively affected if proposed limits on the tax exemption of municipal bonds become a reality.
*Based on preliminary data.
After challenging times during the great recession, Hanan Callas, senior investment analyst in Federated’s tax-exempt money market group, sees positive signs on both the state and local government fronts. “State tax revenues have returned to pre-recession levels; income-tax revenues, which are the largest revenue source, grew by 4.5% in the third quarter of 2012; and sales-tax revenues, the second largest, grew by 3.1%. The states have started to replenish their reserves and employee layoffs have tapered off,” she noted. Despite encouraging signs for economic recovery, however, concern remains as to its robustness. In addition, according to Callas, pension funding requirements continue to occupy center stage and, in some instances, will strain state budgets. States also will have to contend with the implementation of the Patient Protection and Affordable Care Act as much uncertainty remains regarding parts of this legislation.
Federal sequestration has also become a reality, although the impact on the states most likely will be muted and localized. The sequestration was not a surprise as states are expected to have developed contingency plans to mitigate the impact. Medicaid—one of the largest items in any given state budget—was exempt from the cuts, and federal aid reduction to state governments is less than 1%.
Local governments have exhibited encouraging signs as well. Property values appear to have stabilized and started to shift higher in some locations. Most local governments have been successful in managing their budgets so that they are in line with their revenues. Nonetheless, concerns remain regarding pension costs and potential trickle-down effects as states may push down any cuts in federal funding to the local level. Given the sheer number of governmental units that issue debt, money market funds remain selective in evaluating these governments. Extensive credit research and diligence are key factors to ensure proper security selection for the funds.
The Farm Credit System, the Tennessee Valley Authority and the Federal Home Loan Bank System have served their function as Government-Sponsored Enterprises (GSEs) well. Each has shown solid operating performance in recent quarters and their ties to the Federal government remain firm.
Fannie Mae and Freddie Mac, two GSEs that are more often in the news, have reversed poor results and billions of dollars in losses from 2008 through 2011. In 2012, Freddie Mac earned income totaling $11 billion, reversing a loss of $5.3 billion in 2011. Similarly, Fannie Mae had annual net income of $17.2 billion, reversing a loss of $16.9 billion in 2011. Both GSEs are enjoying a rebounding housing market in the U.S., resulting in significantly better credit quality and operating performance.
Both Freddie Mac and Fannie Mae remain under conservatorship, operating under the direction of the Federal Housing Finance Agency. Ratings on the companies match those assigned to the United States: AAA by Moody’s and Fitch, and AA+ by Standard & Poor’s. Financial support from the U.S. Treasury remains in place and, as of January 1, 2013, is defined. Going forward under the U.S. Treasury’s Preferred Stock Purchase Agreement, Freddie Mac will have access to $140.5 billion in funding, if needed; Fannie Mae will have access to $117.1 billion. It is important to note that, to date, Freddie Mac and Fannie Mae have drawn $71.2 billion and $116.1 billion from Treasury, respectively. This support came during the depths of the housing and financial meltdown. The two GSEs have also returned billions of dollars to the U.S. Treasury in the form of dividends. Beginning in 2013, they will pay dividends to the extent that their net worth exceeds a defined capital reserve. Freddie and Fannie’s ties to the U.S. government have never been stronger.
Fannie Mae, Freddie Mac and the Federal Home Loan Bank System debt are primary investment alternatives for government money market funds, as well as the Federal Reserve and central banks around the globe. Each remains critical to the housing market.
When it comes to credit quality, there is no safer source than U.S. Treasury securities and during times of market stress that have been in play since the credit crunch, investors have flocked to them. But along with these periodic stretches of heightened demand, government money funds have had to contend with additional challenges in pursuing supply. “As part of the Fed’s current monetary policy, specifically quantitative easing (QE), some $85 billion per month of a combination of Treasuries and agency mortgage-backed securities have been taken out of the direct markets in an attempt to spur economic growth,” said Sue Hill, senior portfolio manager of Federated government money market funds.
Although the securities the Fed has been buying are longer term and not available for use within money funds, a consequence that does affect them is that these purchases have decreased the amount of repurchase agreement (repo) supply available for funds to invest in. Repos, which are overnight collateralized investments, form the liquidity base for many government money market funds. Where the repo market trades determines where the overall short-term market trades and, consequently, what sort of gross yield money funds can offer. “Because the Fed has been buying large amounts of that collateral and holding it on their own balance sheet, dealers have had less available to do repo-collateralized transactions with money funds,” said Hill. “For the past few years, QE has taken hold of the market, more or less, keeping low short-term rates even lower.”
Hill notes that debate is underway at the Fed about whether they should begin to taper off on these purchases, although any action is not likely to happen until late 2013 into 2014. “We expect the Fed to continue long-term asset purchases until the economy is on firmer ground. Until those purchases do start to diminish, the low interest rate environment will remain in force,” she said.
One positive on the horizon is that the U.S. Treasury is expected to begin issuing floating-rate securities, a concept it has considered for a number of years to help term out some of their debt as well as address the demand for investable securities in the marketplace. “That’s a bright spot in the supply equation, and we’re looking for access to these securities in about a year or so,” said Hill.
The Road Ahead
As credit quality improves across the investment spectrum, finding supply of investable securities, at least in some sectors, is likely to remain a challenge for the immediate future. “But in general,” Cunningham said, “firms for which cash management is a core business and that have the resources to both access supply and scrutinize credit quality are in a strong position to effectively manage this challenge.” Cunningham is also confident that given the essential role of money market funds in both the U.S. and around the world, issuance supply will gradually return to more abundant levels as new structures are developed to accommodate the 2a-7 liquidity and credit requirements.
- With credit quality of most money market fund issuance sectors improving, the major challenge confronting funds today is navigating supply constraints, particularly in a low-rate environment.
- When it comes to determining credit quality, domestic or international, there are no shortcuts. Regardless of the issuing sector, intensive credit work is critical to uncovering unacceptable risks as well as potential investment opportunities.
- The U.S. Treasury is expected to issue floatingrate notes by 2014 in response to market demand for investable securities. It is anticipated that additional structures will be developed to effectively balance this growing need against enhanced liquidity and credit requirements.