Light spotted at end of long and dark CP tunnel

  • 14 Jan 2009
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As liquidity on all but the most highly rated short dated commercial paper has evaporated and prices on various money market assets has fallen below par, money market funds have found the need to change their strategies to survive. Brendan Daly looks at the new shape of the game.

When structured investment vehicles (SIVs) started imploding in 2007 and shaking market confidence, many thought that conditions could not get any worse in money markets.

But they were proven overly optimistic in the wake of Lehman Brothers’ collapse, as money market funds were left exposed to falling prices on financial institution paper in their portfolio.

"I don’t think people were expecting market conditions to continue to deteriorate," says Kathryn Kerle, a senior credit officer at Moody’s in London. "And for money market funds in particular I think the knock-on effect of bank failures and near failures has probably been one of the greatest shocks, because they are so exposed to banks in one way or another."

Despite the deterioration of the situation in money markets, European funds remained fairly robust.

"Of the triple-Am rated money market funds in Europe that we monitor, which represent roughly 45% of money market fund assets in Europe, none experienced any decrease in their NAV and they were able to maintain principle value," says Francoise Nichols, a director within the financial institutions rating group at Standard & Poor’s in Paris.

Nonetheless, some European funds have restructured. In November, Aviva Investors changed the terms of its sterling and euro liquidity funds so pricing can fluctuate according to mark-to-market valuations, moving to a variable net asset value policy where price varies while the yield is left untouched.

Both funds previously used a constant net asset value policy to keep NAV stable at £1 a share.

Some fear that such changes, which could potentially allow funds to break the buck, may rob them of their unique selling point and make them less attractive.

"Money funds need to be super-safe, offer easy redemption terms, and have a yield higher than bank deposits," says Peter Eisenhardt, head of CP at Bank of America and chairman of the ICMA ECP committee. "Any modifications to the structure need to bear this in mind"

Nichols also notes the flight of investors from money market funds to bank deposits.

"Money market funds are suffering outflows not only because of investors’ risk aversion, but also because of stiff competition from banks. Banks need deposits right now and offer very attractive rates."

Borrowers are increasingly concerned about the names behind funds.

"We noticed a correlation between the market’s perception of the credit quality of a sponsor as reflected in its share price performance and vulnerability to redemptions," says Kerle. "So the crisis has revealed the interplay between fund and sponsor. On one hand, funds that have experienced credit events have often benefited from sponsor support and therefore not broken the buck or had other problems. But some funds whose sponsors came under assault found themselves facing redemptions of historic proportions."

Market conditions have not always been a nightmare for fund managers; they have sometimes been a boon.

Chris Oulton, CEO of Prime Rate Capital Management, notes one example. "We bought some seven day paper at a yield of about 16%, which is ridiculous; it’s high quality paper. That shows the extent of the lack of liquidity in the secondary market, that there are still distressed sales of high quality paper at prices which really don’t make any sense at all. And we’ve seen a number of similar things."



Money market funds in the US have experienced worse turmoil than their European counterparts.

The scale of the US problem became clear when, two days after Lehman Brothers collapsed, Reserve Primary Fund filed for bankruptcy. The fund is the oldest US money market mutual fund, and the first fund to break the buck since 1994.

The US funds suffered worse partly because of their holdings of Lehman paper. "We didn’t see as much exposure of Lehman Brothers CP in European money market funds as in the US," says Andrew Paranthoiene, a credit analyst at S&P. "The small number of exposures were to be found in overnight and collateralised repo transactions or swap transactions in bond funds, but there was no exposure of Lehman Brothers CP in S&P rated European money market funds. In the US, money market funds held much more Lehman Brothers CP and a couple of funds, like the Reserve Primary Trust fund, ended up breaking the buck."

Authorities could not allow further problems with the funds and had to intervene. The Federal Reserve’s solution was a host of programmes with acronyms as long as Ben Bernanke’s arm, such as the CPFF, MIFF and ABCPMMMFLF.

Though the programmes have had some success in resuscitating the USCP market and easing liquidity, nothing similar has been implemented in Europe or seems likely to be.

"At the moment the European legislators and regulators are watching what they have done to see whether or not it assists," says Nathan Douglas, secretary general of the Institutional Money Market Funds Association in London. "But I think it’s unlikely now that any additional changes will be made unless we see a significant shift in what’s going on in markets again."

If authorities do deem such actions necessary and appropriate, they could potentially boost the market even further.

"There are some signs that liquidity is returning as a result of the Fed’s actions, and it would be interesting to see whether we see anything similar emerging in Europe," says Oulton. "There is certainly interest from market participants for a similar sort of facility."

However, the different situation in Europe makes such an approach less likely.

"Money funds in Europe are smaller commpared with the US and across the board have well capitalised bank sponsors," says Eisenhardt. "Also, ABCP is less a factor in Europe."


Overnight feels right

As funds have had to worry about increased redemption requests in the face of illiquid secondary markets, average tenors in the ECP market have fallen sharply in recent months, and there has been consistent demand for overnight CP.

Paranthoiene notes that weighted average maturities in rated money market funds have dropped in the months following the Lehman catastrophe from an average of 32-35 days to about 23-26 days across the three major currencies.

This has meant a decrease in the proportion of funds’ assets held as CP, as opposed to CDs or other assets.

"The way money market funds invest is dictated by what their client needs are, so the reason that there was a reduction in the purchase of commercial paper was that funds needed to be in a position to deal with any redemption requests received," says Douglas.

Oulton adds that Prime Rate, like most funds, has reduced maturities to well below their limits to ensure liquidity.

Though there is still some way to go, some believe the situation may be getting better. "We’ve noticed improvement," says Oulton. "When we buy commercial paper for our fund we’ve found that some of the outrageously cheap offers in the secondary market are not as easy to come by."

Oulton expects that improvement to continue. "We’d expect to see liquidity continue to return to the secondary market. The thing that people will be most concerned about is testing the extent of secondary market liquidity."

It is likely, though, that investors will stick to safety for the foreseeable future. "I think people will be very selective about what they’re buying, they’ll be very cautious about it, with an eye on underlying liquidity," says Oulton. "And an awful lot of CP is more suitable for buying and holding to maturity, 75% of the paper is not triple-A rated."


Safety first

Since the announcement of guarantees for bank debt from the UK, Irish, and other governments, banks have issued large volumes of guaranteed paper in the ECP market. This paper is likely to remain a popular option, given the safety it provides.This, along with issuance from traditional triple-A rated issuers that has been lapped up by investors over recent months, is likely to make up the bulk of CP purchases in longer maturities.

"Bank guaranteed paper will be popular," says Oulton. "One of the interesting issues is going to be the distinction between government debt and debt issued by highly rated financial institutions, who themselves are government supported."

The increased competition may hurt SSA borrowers, as they struggle to compete with the new triple-A products. "I would expect to see yields rise relatively on government debt to top rated financial debt, because the top rated financial debt is itself now essentially government guaranteed," says Oulton. "So you’d expect that spread to move right back, because one of the features of 2008 was the widening of spreads as governments became the only safe haven because nobody trusted any of the banks."

Oulton adds that he also expects spreads on non-guaranteed bank paper to tighten because of the belief in an implicit guarantee. However, he expects that even the guaranteed paper will continue to be subject to liquidity concerns, and this will affect both average maturities and distribution by jurisdiction.

Kerle agrees that, as popular as guaranteed paper may be, investors will still stick to shorter maturities over the coming months. "We’ve had a number of enquiries over the last couple of weeks about the risk of money market funds investing in securities issued by government-guaranteed banks," she says. "Many fund managers are interested in this asset class. But, as with all assets, as long as managers are not confident that they can sell at par to the secondary market they will be very reluctant to move out much in terms of weighted average maturity, because they have to be able to meet investor redemptions."

Things may become easier for banks that have their governments behind them, but most non-triple-A borrowers are likely to find that the ECP market remains an inhospitable place.

Investors are also going to remain choosey when deciding what issuers’ paper they can purchase. "Generally I think there is a greater focus on in-house credit research, which has been greatly strengthened. Money market managers have reduced the number of eligible names and have become choosier in selecting their assets," says Nichols.

Whoever the issuer and whatever the product, all parties agree that transparency has become of the utmost importance.

"We find in our own fund, where people would have said ‘you’re a triple-A rated liquidity fund so you’re safe and that’s easy’, we’re now having to explain what it is we do that gives rise to the rating agencies feeling comfortable to give us a triple-A rating," says Oulton. "So that’s a level of explanation that you wouldn’t have had to give a year ago."

Many funds have had to enhance their investor education. "From our conversations with fund groups, one of the key things that has changed in the last 12 months is that of portfolio holdings disclosure," says Paranthoiene. "Although money market funds contain high credit quality, liquid investments, there were still concerns from investors as to the portfolio holdings. Fund groups in response have increased significantly their dialogue to investors and ramped up their education about money market funds, which is a positive action."

Sooner or later, funds are going to have to start seeking higher yields if the money market fund model is to remain sustainable and funds are to compete with deposits.

"Eventually money market fund investors will find yield important, and not settle for T-bill type returns only," says Eisenhardt.

  • 14 Jan 2009

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