Bond Markets & Research

• Market Update
• Newsletter
• Research
• Resources
• Treasury Yield Curve

Regulation Redux - Government puts final touches on new money market guidelines

Eric Hiatt, CFA
Senior Portfolio Manager

On January 27, the Securities and Exchange Commission adopted amendments to Rule 2a-7 and related rules in an effort to overhaul the governance of money market funds. The changes, which were enacted in the wake of the financial crisis and the Reserve Primary Fund subsequently “breaking the buck,” aim to increase transparency, decrease risk, and ultimately provide more protection for money market fund investors. (A table below summarizes the major changes to Rule 2a-7 along with associated phase-in dates.)

In anticipation of the new guidelines taking effect, many managers are shortening the weighted-average maturities of their funds in order to comply with the new weighted-average maturity limitation of 60 days. The weighted-average life calculation, which looks to the final maturity of securities, will be limited to 120 days (we have been a proponent of these restrictions for some time now, as they limit managers’ ability to mask credit duration with the use of floating rate notes). In addition, many managers are now increasing their allocation to U.S. Treasuries, which are considered ultra-liquid and meet the new daily and weekly liquid asset restrictions no matter the tenor.

We will be closely watching the effect that these new rules have on the supply and demand dynamics in the money market space. For instance, the new liquidity provisions will significantly restrict investment beyond 30 days for a portion of the $2.6 trillion taxable money fund sector. According to our estimates, this may result in an additional $300 billion of cash chasing limited supply in the 1- to 30-day maturity range. Conversely, bank regulators in the United States and abroad have been appealing for banks to term out their funding beyond one year in an effort to bolster the long-term structural funding of banks’ balance sheets. These opposing forces may combine to result in a steepening of the money market yield curve.

Decompression of the LIBOR curve is already taking place despite the message from the Federal Reserve that it is prepared to keep the federal funds rate, or target interbank lending rate, exceptionally low for “an extended period.” Albeit slight, the backup in rates has seen 3-month LIBOR increase nearly 5 basis points to 0.29% from the historically low levels reached in the fourth quarter of last year, marking the first consecutive monthly increase since September 2008. This dynamic may be attributable in part to the announcement by the U.S. Treasury of an increase in the Supplementary Financing Program from $5 billion to $200 billion. (The SFP was used to fund various Federal Reserve liquidity programs during the height of the credit crisis.) The increase in T-bill supply is being embraced by money market investors and is forcing banks to increase offered rates as they have to contend with fewer assets in the front-end of the curve.

The SEC has codified changes to the governance of money market funds that are slated to begin taking hold this coming May. The new rules, which were enacted to increase the safety and transparency of money market funds, will limit the ability of managers to take unwarranted risks. Dwight is welcoming the changes, many of which we have been advocating for some time. Returning to more conventional regulations will ultimately place a renewed emphasis on process and management expertise, improving the soundness of 2a-7 money market funds for investors.

MAJOR CHANGES TO RULE 2a-7

AS OF MAY 5, 2010:
Redemptions: The board of directors will be permitted to suspend redemptions if the fund is in jeopardy of breaking the buck. Previously, the board was required to request an order from the SEC to do so.

Affiliate purchases: The new rules permit affiliates of money market funds to purchase distressed securities from the fund for any reason without first requesting permission from the SEC.

AS OF MAY 28, 2010:
Liquidity: Money market funds will be required to maintain at least 10% in daily liquid assets and 30% in weekly liquid assets. Funds will be restricted to holding no more than 5% of their assets in securities deemed to be illiquid.

“Know your investor”: Funds should adopt “know your investor” procedures with respect to holding sufficiently liquid assets to meet potential redemptions.

Credit: Funds will be prohibited from investing more than 3% of their assets in second-tier securities and more than 0.5% in any one second-tier issuer. Second-tier securities may not be acquired if they have a remaining maturity greater than 45 days.

Stress testing: The board of directors should adopt procedures for periodic testing of a fund’s ability to maintain a $1 net asset value under a range of market conditions.

AS OF JUNE 30, 2010:
Duration: Funds will be limited to a weighted-average maturity of 60 days and a weighted average life of 120 days. The weighted-average life utilizes the final maturity date in its calculation while the weighted-average maturity utilizes the reset date.