INDUSTRY OUTLOOK

MANAGED INVESTMENTS DECEMBER 12, 2013

Table of Contents:

SUMMARY OPINION 1 2014 OUTLOOK 2

Smaller and Less Profitable Industry 2 New Regulations Will Reshape MMF Industry – Impact Uncertain 3 Bank and Sovereign Rating Transitions Continue to Pressure MMF Credit Profiles 5 Sluggish Economic Recovery Likely to Keep Short-Term Rates Low 7 Supply Constraints Remain a Challenge 8

MOODY’S RELATED RESEARCH 11

Analyst Contacts:

NEW YORK +1.212.553.1653

Robert M. Callagy +1.212.553.4374 Vice President – Senior Analyst robert.callagy@moodys.com

PARIS +33.1.7070.2229

Vanessa Robert +33.1.5330.1023 Vice President - Senior Credit Officer vanessa.robert@moodys.com

Yaron Ernst +33.1.5330.1027 Managing Director - Managed Investments yaron.ernst@moodys.com

Credit Policy Contact:

NEW YORK +1.212.553.1653

Barbara Havlicek +1.212.553.7259 Senior Vice President barbara.havlicek@moodys.com

» contacts continued on the last page

2014 Outlook - Money Market Funds Outlook Is Stable As Fund Managers Tread Carefully Given Supply Constraints, Regulatory Reform

Summary Opinion

Our outlook for money market fund (MMF) ratings is stable. We do not expect significant shifts in MMFs’ credit or stability profiles over the next year. Fund managers remain cautious in the face of persistent supply constraints, potential shifts in monetary policy, political gridlock in the US and Europe, and looming regulatory reform.

The biggest story in 2014 will likely be the finalization—or near finalization—of new MMF regulations in both the US and Europe. Regulatory reforms that were proposed in 2013 will likely result in dramatic changes to the MMF product, to investor preferences, and transform the industry as a whole. Overall, regulatory changes will serve to protect MMF investors by addressing structural vulnerabilities and attempting to reduce systemic risk associated with MMFs.

The low interest rate environment will continue to pressure fund yields and MMF managers’ profitability. Persistent low rates will drive more investors out of MMFs in both Europe and the US, and will push fund managers to maintain “barbelled” portfolio strategies. MMFs that implement such “barbelling” strategies - focusing simultaneously on both the low and high ends of a credit and/or maturity range - will have greater pressure on their credit and stability profiles.

Profitability pressures will drive further industry consolidation. Fee waivers, a function of low gross yields, will continue to be a drag on asset managers’ revenues and earnings. New compliance and operational requirements in regulatory reform proposals will add further expense to MMF managers’ cost structures, strengthening the advantages of large players with more scale and broader client relationships. The trend towards greater industry concentration will continue in 2014 as more small- to medium-size players exit the market or sell out to larger MMF aggregators.

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INDUSTRY OUTLOOK: 2014 OUTLOOK - MONEY MARKET FUNDS: OUTLOOK IS STABLE AS FUND MANAGERS TREAD CAREFULLY GIVEN SUPPLY CONSTRAINTS, REGULATORY REFORM

2014 Outlook

Smaller and Less Profitable Industry

Further Shrinkage in AUM Accommodative monetary policy from central banks globally will keep short-term interest rates low over the next 12 to 18 months. Persistent low short-term interest rates combined with regulatory fatigue will drive investors out of MMFs both in Europe and in the US. MMF outflows will likely accelerate if final regulatory reforms are at the conservative end of the range of expected outcomes.

EXHIBIT 1

AUM of US (right axis) and European (left axis) MMFs

Source: European Fund and Asset Management Association (EFAMA) and iMoneyNet

Profitability pressures drive further industry consolidation Fee waivers, a function of low gross yields, will continue to be a drag on asset managers’ revenues and earnings, and we do not see near-term catalysts that would materially change this outlook.

EXHIBIT 2

30-Day Net Yield of Euro-Denominated CNAV MMFs in Europe and US Prime Funds

Source: iMoneyNet

New compliance and operational requirements in regulatory reform proposals will add further expense to MMF managers’ cost structures, strengthening the advantages of large players with more scale and broader client relationships. The trend towards greater industry concentration will continue in 2014 as more small- to medium-size players exit the market or sell out to larger MMF aggregators.

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In 2013, we saw a number of consolidating transactions globally, including Reich & Tang’s acquisition of Highmark Capital Management’s MMF business and Goldman Sachs Asset Management’s acquisition of RBS’s MMF business. Aberdeen Asset Management plc also announced in October its intention to buy Scottish Widows Investment Partnership’s £20 billion money market fund and cash business from Lloyds Banking Group plc. The number of fund complexes offering CNAV products now in Europe stands at 27 versus 45 at the end of 2007. Over this period, the market share of the top 10 firms increased to 81% from 61% of net assets.1 A reduced number of management firms means there are fewer MMFs available to investors (see exhibit 3).

EXHIBIT 3

Number of MMFs in US and Europe

Source: EFAMA and iMoneyNet

New Regulations Will Reshape MMF Industry – Impact Uncertain

Regulatory changes will increase protection to MMF investors by addressing structural vulnerabilities and attempting to reduce systemic risk associated with MMFs both in the US and in Europe. However, the next phase of regulatory reforms is likely to significantly change the MMF product structure, investor preferences and the industry as a whole.

Expected impact of proposed new rules on MMFs

US

In June, the US Securities and Exchange Commission (SEC) proposed two alternatives to tighten regulations governing the US MMF industry2. The proposals involved fewer structural changes to the MMF industry than the range of alternatives the industry originally anticipated.

The SEC made two proposals which apply to overlapping subsets of prime MMFs. For institutional prime MMFs (funds containing more than 20% corporate credits that allow withdrawals of more than $1 million per day, per customer) the SEC proposed a variable net asset value (VNAV) structure to replace the current constant net asset value (CNAV) structure. For institutional and retail prime MMFs, the SEC proposed a withdrawal fee of 2% and allowing boards to suspend redemptions for 30 days in times of stress. US government funds (funds containing more than 80% government securities) are excluded from both proposals. The treatment of tax-free municipal funds has yet to be determined.

1 Source : iMoneyNet. 2 Please see “Limited Reform Proposal Is Credit Positive for US Money Market Fund Managers” published in September 2013.

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For MMF investors, the shift to a VNAV structure is positive from a credit perspective, because redemptions from VNAV funds will more accurately reflect the market value of the funds’ underlying securities and, as a result, more closely align all investor interests. The current CNAV structure allows for potential arbitrage in times of market stress: By selling at a fixed $1 price when the market value of MMF shares may be lower, redeeming shareholders can benefit at the expense of those who remain invested. Because the proposed VNAV structure seeks to mitigate this risk by aligning its redemption price with its market value, accurate and timely pricing of the underlying securities in MMFs will become even more critical.

The second alternative, that includes liquidity fees and redemption gates, also provides disincentives for investors to run. However, investors would have less access to liquidity than they now do.

Europe

In September, the European Commission (EC) published proposals for a new regulatory regime for MMFs3 domiciled, managed and/or marketed in the European Union (EU)4.

The proposed rules introduce new or expanded regulatory requirements for MMFs and their managers, some of which are already implemented at the European level via the European Securities and Markets Authority (ESMA) guidelines and/or voluntarily carried out by managers based on the Institutional Money Market Fund Association (IMMFA) Code of Conduct.

The EC proposal includes:

» 3% capital buffer requirement for CNAV MMFs. This is the most significant proposal, as it would alter MMFs’ business model.

» Restriction on weighted average maturities and weighted average lives. This will have no impact on funds as these rules are already embedded in ESMA guidelines.

» Minimum daily and weekly liquidity requirements. This requirement – already implemented by most CNAV portfolio managers based on the IMMFA Code of Conduct – is expected to make MMFs more resilient to large redemption requests.

» Issuer and counterparty concentration limitations. This requirement will strengthen MMF diversification and make the funds less vulnerable to the risk of credit losses in case of liquidation or market value declines.

» Restrictions on the use of asset-backed commercial paper and reverse repurchase agreements. This will reduce available supply for MMFs.

» Ban on amortized cost accounting.

» Overhaul of funds’ credit process.

» Ban on funds’ soliciting or paying for a rating.

Overall, we expect the majority of these proposals to strengthen the asset and liquidity profiles of European MMFs. However, the benefit of some of the proposals is still debated.

3 Please see “European Commission Proposals Are Credit Negative for Money Market Fund Managers” published in September 2013. 4 The proposed regulation must go through the EU’s legislative process before approval and implementation.

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Expected impact of proposed new rules on MMF sponsors

US

The proposed reforms will likely result in loss of AUM and higher operating costs for MMF managers. The impact will vary based on the sponsors’ AUM exposure to the fund segments affected by the proposed rule changes, as well as on the firms’ ability to recapture regulatory-driven AUM loss through their own government MMFs or alternative liquidity products.

If the VNAV alternative is adopted, we would expect significant outflows from prime institutional MMFs. Our redemption projections reflect the following observations: 1) investment policy guidelines for many institutional investors may not permit investments in MMFs with VNAV structures; 2) investors have little to no tolerance for loss in a cash investment; 3) investors’ rights will be severely affected by the potential loss of access to intra-day liquidity, and 4) the treatment of MMF investment will be materially altered by the loss of its qualification as a cash equivalent and tax inefficiencies from fractional penny gains and losses. Additionally, our projections take into consideration results from the Association of Financial Professionals (AFP) 2013 Liquidity Survey in which 65% of surveyed respondents5 indicated their intention to reduce or sell all holdings in MMFs upon a change to a VNAV structure.

If the liquidity fee and redemption gate alternative is chosen, we also expect investor outflows, and the magnitude of expected outflows would likely be greater than those under the first alternative. A larger subset of MMFs is affected by the second alternative, and investors would likely react more negatively to any change that restricts access to liquidity. Many institutional investors use MMFs as a parking place for operating cash balances which serve to fund payrolls, operating expenses, debt repayment, etc. As such, we view redemption gates as a much less palatable option for investors than a VNAV structure.

Europe

A capital buffer requirement could indirectly impose the VNAV structure, because the unfavorable economics of the capital buffer would make the CNAV MMF product unprofitable.

If capital buffer costs are passed through to investors in the form of additional fees (or lower yields), investors will likely move their money into more competitive alternative money market investments6. That said, even if CNAV funds are transformed into VNAV MMFs, the existing AUM balances will likely decline, as this type of fund may be less attractive to institutional investors for tax and accounting reasons.

While capital in the form of support from MMF fund sponsors has generally been effective in immunizing investors from idiosyncratic risks, the proposed EC regulation would prohibit external support, including cash injections and implicit or explicit guarantees. This change makes clear that MMFs are not a guaranteed product but rather an investment vulnerable to losses, a realization that will likely push more investors out of MMFs.

Bank and Sovereign Rating Transitions Continue to Pressure MMF Credit Profiles

The significant exposure of MMFs to financial institutions and sovereigns makes them vulnerable to any changes in the creditworthiness of these two sectors (see exhibit 4).

5 Survey respondent are U.S. corporate investors of varying size, 2013 AFP Liquidity Survey Introduction and Key Findings. 6 Please see “Money Market Funds and Regulatory Reform: A Business Model Hangs in the Balance”, published in May 2013.

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EXHIBIT 4

Key sovereign and banking system ratings and outlooks as of 25 November 2013

Government Bond Rating -

Local Currency Outlook Banking System Rating -

Local Currency Outlook

Australia Aaa Stable Aa2 Stable

Canada Aaa Stable Aa2 Stable

France Aa1 Negative A2 Negative

Germany Aaa Negative A3 Stable

Japan Aa3 Stable A1 Stable

Netherlands Aaa Negative A1 Negative

Norway Aaa Stable A1 Stable

Singapore Aaa Stable Aa1 Negative

Sweden Aaa Stable Aa3 Stable

Switzerland Aaa Stable A1 Stable

United Kingdom Aa1 Stable A2 Stable

United States of America Aaa Stable A2 Stable

Source: Moody’s Investors Service; key designation based on the most sizeable exposures in prime MMFs.

The challenging credit environment is demonstrated by the number of issuers whose ratings are either on review for possible downgrade or whose rating outlooks are negative. The percentage of financial institutions on review for possible downgrade globally was 4% in December, while the percentage of negative outlooks stood at 28%. The credit environment is particularly challenging in Europe, where the percentage of financial institutions whose ratings are currently on review for possible downgrade stands at 6%, while 40% carry negative outlooks (see exhibit 5).

EXHIBIT 5

Status of financial institutions’ ratings as of 9 December 2013

Source: Moody’s Investors Service

In this context, we expect to see a continued increase of MMF investments into strong financial banking systems such as the Australian, Singaporean and Nordic systems.

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Sluggish Economic Recovery Likely to Keep Short-Term Rates Low

Moody’s expects interest rates to remain at historically low levels throughout 2014 (see exhibit 6). Low rates on high quality, short-term investments will continue to challenge money market funds’ return profiles.

EXHIBIT 6

Short Term Interest Outlook in Percentage as of 25 November 2013

Source: Moody’s Analytics

US

The timing of the Federal Reserve (Fed) tapering will be a central focus in 2014. Given the unprecedented support measures, the tapering process is unlikely to be smooth and orderly, so financial markets are likely to remain volatile.7 Even if the Fed begins to reduce monthly asset purchases, Moody’s believes the Fed will remain committed to very low short-term rates throughout 2014.

The Fed’s establishment of a fixed-rate full allotment reverse repo facility will be a positive for MMFs in 2014. The facility will tend to set a floor on money market rates, reducing the risk of increased fee waivers of money market fund fees. Investors are not likely to accept lower overnight lending rates than the benchmark rate paid by the Fed. The rate backstop will help money market fund managers, who have struggled to generate returns in a low-yield environment, and continue to waive management fees in order to deliver a positive net yield.

Europe

The European Central Bank (ECB) is committed to leaving rates at current or lower levels for an extended period of time. While the first deadline for paying back some EUR1 trillion in loans is in December 2014 (the second deadline is in February 2015), banks have started making long-term refinancing operation (LTRO) repayments in January. As a consequence, excess liquidity in the euro-area financial system fell to EUR187 billion in October. This was the lowest level in two years and the first time excess liquidity has fallen below EUR200 billion — a threshold once set by the ECB as the lower boundary of accommodative monetary policy.

7 Global Macro Outlook 2013-15: Navigating towards calmer waters.

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Falling liquidity levels coupled with the prospect of the first repayment deadline had an impact on the one-week Euribor - a key measure of shorter-term bank borrowing rates - making it increase to 0.130% in the beginning of December from 0.08% in January. But if changes in money market conditions were deemed to be unwarranted on the view of the monetary policy stance, the ECB would “stand ready to act” against rising interest rates in money markets, because they could endanger the recovery. In November, the ECB left the interest rate on the deposit facility at 0% but reduced the interest rate on the main refinancing operations of the Eurosystem by 25 basis points to 0.25%, increasing the likelihood of use of unconventional tools in case the economic recovery stalls.

The President of the ECB told the European Parliament in September that he was indeed ready to deploy another LTRO and provide additional emergency loans to banks to keep borrowing costs low. A new LTRO would be negative for euro-denominated prime MMFs. It would lead to increased bank borrowings from the ECB rather than from euro money markets, pressuring yields lower. With fewer borrowers, European MMFs would experience a deterioration in the profile of their investment portfolios as asset concentrations increased. A new LTRO would also lead money fund managers to extend their investments’ maturities toward the upper limits of investment guidelines to increase yield.

The Bank of England (BOE) maintained throughout the year the official bank rate paid on commercial bank reserves at 0.5%, as well as the stock of asset purchases financed by the issuance of central bank reserves at £375 billion. In October, the BOE also announced an overhaul of its money-market operations to widen access and cut the cost of liquidity insurance to the financial system. The central bank will offer money over longer periods, expand the range of collateral it accepts to raw loans and charge lower fees, in some instances the fees are being more than halved. This decision will lower returns of Sterling-denominated MMFs.

Supply Constraints Remain a Challenge

The availability of short-dated, high quality eligible investments for MMFs will continue to shrink driven by high demand and a shortage of new supply (see exhibits 7-11).

EXHIBIT 7

Issuance of Euro-Denominated Short Term European Paper (Euro billion)

Source: European Central Bank

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EXHIBIT 8

EMEA ABCP Outstanding ($ billion)

Source: Moody’s Investors Service

Regulatory disincentives for financial institutions to rely on short-term funding will limit the availability of high quality short-dated instruments. Central banks’ potential injection of cheap money into the financial system, and limited availability of asset-backed commercial paper, will also constrain the supply.

Given the lack of asset supply, MMFs will invest more in highly rated short-term government debt securities. The US Treasury’s expected issuance of floating-rate notes in 2014 will bring a welcomed investment product to MMFs. Further, a reduction in the US Federal Reserve’s $85 billion monthly asset purchases will increase the amount of repo supply available to MMFs.

EXHIBIT 9

US CP Outstandings ($ billion)

Source: SIFMA

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EXHIBIT 10

US Treasury Bill Outstandings ($ billion)

Source: SIFMA

EXHIBIT 11

US Agency Debt (<1 year debt) Outstandings ($ billion)

Source: SIFMA

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Moody’s Related Research

Outlooks:

» 2014 Outlook - Global Asset Management (161411)

» 2014 Outlook - Closed-End Funds (to be published in January 2014)

» 2014 Outlook - Bond Funds (to be published in January 2014)

Special Comments: » Money Market Fund Rating Profiles, December 2013 (160734)

» Money Market Funds: Structural changes to combat negative yields are credit neutral, March 2013 (151296)

» Money Market Funds and Regulatory Reform: A Business Model Hangs in the Balance, May 2013 (153634)

» US-Dollar Prime Money Market Funds Q3 2013 Trends: Credit and Liquidity Improve in Response to Debt Ceiling Impasse, October 2013 (159748)

» Euro Prime Money Market Funds Q3 2013 Trends: Shortest Average Maturity Since July 2012 and Improved Market-Risk Profile, October 2013 (159698)

» Sterling Prime Money Market Funds Q3 2013 Trends: Market-Risk and Credit Profiles Improve, October 2013 (159703)

Rating Methodology:

» Moody’s Revised Money Market Fund Rating Methodology and Symbols, March 2011 (131303)

Rating Implementation Guidance: » Detailed Guidance on the Application of Moody’s Money Market Fund Rating Methodology,

August 2011 (132916)

Website: » Managed Investments on Moodys.com

To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of this report and that more recent reports may be available. All research may not be available to all clients.

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INDUSTRY OUTLOOK: 2014 OUTLOOK - MONEY MARKET FUNDS: OUTLOOK IS STABLE AS FUND MANAGERS TREAD CAREFULLY GIVEN SUPPLY CONSTRAINTS, REGULATORY REFORM

Report Number: 160944

Authors Vanessa Robert Robert M. Callagy

Production Associate Vikas Baisla

© 2013 Moody’s Investors Service, Inc. and/or its licensors and affiliates (collectively, “MOODY’S”). All rights reserved.

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» contacts continued from page 1

Analyst Contacts:

LONDON +44.20.7772.5454

Soo Shin-Kobberstad +44.20.7772.5214 Vice President - Senior Analyst soo.kobberstad@moodys.com

Marina Cremonese +44.20.7772.8621 Assistant Vice President - Analyst marina.cremonese@moodys.com

Evangelia Gkeka +44.20.7772.5548 Analyst evangelia.gkeka@moodys.com

NEW YORK +1.212.553.1653

Neal M. Epstein, CFA +1.212.553.3799 Vice President - Senior Credit Officer neal.epstein@moodys.com

Stephen Tu +1.212.553.4935 Vice President - Senior Analyst stephen.tu@moodys.com