Putnam Perspective: Money market (in)eligible

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Recent revisions to the rules governing money market funds are designed to address their susceptibility to heavy redemptions, to seek to improve their ability to manage any potential contagion resulting from redemptions, and to increase fund transparency.

Transcript of Putnam Perspective: Money market (in)eligible

  • 1.PUTNAM INVESTMENTS | putnam.com Since 2008, money market funds have received much attention from regulators relating to concerns about their stability and transparency. In this piece, we take a look at recent money market reforms and highlight some of the Securities and Exchange Commission (SEC) proposals on the horizon today. Then, we delve into the opportunities we see opening up for investors. As money market funds are further redefined by regulation, we believe there are more investment opportunities emerging for funds sitting just outside the SEC Rule 2a-7 money market boundaries. Money market reforms of 2010 In 2010, approximately two years after the oldest money market fund in the United States broke the buck, the SEC altered the regulatory regime governing money market funds by rolling out a series of changes to Rule 2a-7 under the Investment Company Act of 1940. The amendments to Rule 2a-7 enacted in 2010 (the 2010 amendments) included changes to the quality, liquidity, and reporting requirements, as well as changes to the allowable weighted average life of the portfolio holdings of money market funds. However, we believe the restrictions with the greatest impact on the marketplace were the new requirements governing liquidity and further restrictions on the length of the weighted average maturity (WAM) of money market funds. Improved liquidity The 2010 amendments included a series of liquidity rules, including a requirement that money market funds maintain minimum percentages of their assets in highly liquid securities so that those assets could be readily converted to cash in order to pay redeeming shareholders. Previously, there were no minimum daily or weekly liquidity requirements. The 2010 amendments included two key daily liquidity requirements: First, money market funds were required to maintain at least 10% of fund assets in securities that may be converted to cash in one day (overnight liquidity); second, they were required to maintain at least 30% of fund assets in securities that may be converted to cash in seven days (weekly liquidity). Shorter maturities The 2010 amendments also shortened the WAM limits for money market funds. This facet of the rules was intended to help limit the exposure of funds to certain risks such as sudden movements in short-term interest rates. Specifically, the rules restricted the maximum WAM of a money market fund to 60 days which marks a 30% shortening from the previous maximum WAM of 90 days. Regulators recent proposals to revisetherulesgoverningmoney market funds are designed to address the funds susceptibility to heavy redemptions, to seek to improve their ability to manage any potential contagion resulting from redemptions, and to increase fund transparency. New reform proposals include moving to a floating net asset value (NAV) for prime/non-government or institutional money market funds and establishing liquidity fees and/or temporary redemption gates under certain circumstances, or some combination of these proposals. In our view, the universe of money-market-eligible securities continues to shrink due to regulatory action in recent years, but we see attractive opportunities just outside its borders. Keytakeaways FOR INVESTMENT PROFESSIONAL USE ONLY. Not for public distribution February 2014White paper Money market (in)eligible: An update on reform and emerging opportunities Joanne M. Driscoll, CFA Portfolio Manager Jo Anne Ferullo, CFA Investment Director

2. PUTNAM INVESTMENTS | putnam.com 2 FEBRUARY 2014 | Money market (in)eligible: An update on reform and emerging opportunities Proposals for further reform The 2010 amendments had a significant impact on money market funds as well as the issuers that histori- cally have found these funds to be willing buyers of their short-term debt. While the 2010 amendments enhanced the transparency and conservative portfolio posture of money market funds, we believe they also made it more challenging for money market funds to outperform. In an already yield-starved environment, we believe shorter maturities and stricter liquidity requirements have kept a tight rein on the ability of money market funds to generate income. However, despite the changes implemented through the 2010 amendments, the SEC continues to articulate what they have indicated is a fundamental concern, which was not directly addressed by the 2010 amend- ments: Money market funds continue to have liquidity risk in the event of a rush to redemption but have limited capacity to absorb potential losses. Because of this issue, the SEC has indicated that money market funds remain a threat to the stability of the financial system. Consequently, throughout 2012, the SEC internally debated possibilities for further money market reform, which was widely reported in the media as potentially including changing from a stable $1 net asset value (NAV) to a floating NAV, requiring funds to be injected with capital or to create a capital cushion from earn- ings, and/or holding back some percentage of any redemption for a specified time frame. These ideas, which proved to be controversial, were tabled in August 2012 as then SEC Chairman Mary Shapiro indicated that a majority of the SECs Commissioners would not support the SEC staffs then-current proposal to reform money market funds. Subsequently, the Financial Stability Oversight Council (FSOC), which was established under the Trea- sury as a result of the Dodd-Frank financial reform act, recommended three alternatives for further money market reform by the SEC in November 2012. The alternatives were variations of the SEC-debated ideas, including converting to a floating NAV. The latest proposals With the 2013 appointment of a new SEC Chairman, Mary Jo White, the SEC has again picked up the torch of money market reform. In June 2013, the SEC proposed additional amendments to Rule 2a-7 that could result in different requirements for institutional funds versus retail and government money market funds. The floating NAV, the SEC suggested, might be more appro- priately applied to institutional money market funds, because these vehicles are dominated by institutional investors who, regulators worry, could stage a repeat of the 2008 run on money market funds if asset values suffered major deterioration. The SEC also proposed the application of liquidity fees, specifically to help stave off potentially harmful redemption behavior during times of stress, among other objectives.*These fees could be levied in the event a funds weekly liquidity fell below 15% of its total assets, assuming a funds board of directors finds that such fees do not run counter to the best interests of the funds shareholders. In addition, the fund could be gated, effectively putting a temporary halt to all redemption activity for a 30-day period unless the funds board determines that taking this action would not be in the best interest of shareholders. While the governing objective of such regulation is to reduce run risk and enhance the transparency and stability of money market funds, many investors and money managers are concerned that a floating NAV structure, in particular, might steer more individuals and institutions away from money market funds. With essentially zero short-term yields in todays low- interest-rate environment, anything that undermines the perceived price stability of the asset class and that could cause a negative price return is predictably being greeted with some skepticism in the marketplace. 1 See the Opening Statement at the SEC Open Meeting, June 5, 2013: http://www.sec.gov/news/speech/2013/spch060513mjw.htm Figure 1.Money market fund timeline First money market fund established The buck breaks at Reserve Primary Fund in the wake of systemic nancial market stress FSOC recommends alternatives for money market reform, including a oating NAV and capital buffers SEC amends Rule 2a-7, resulting in new requirements for portfolio liquidity, maturity, credit quality, disclosure, stress testing, and operations Reform debate continues, with new proposals issued by the SEC in June 2013 20081971 2010 20132012 3. PUTNAM INVESTMENTS | putnam.com 3 FEBRUARY 2014 | Money market (in)eligible: An update on reform and emerging opportunities Opportunities in a climate of continuing reform Quite simply, over the past two to three years it has become a significant challenge for money market funds to pursue and achieve their typically secondary objective of providing income. This challenge will likely continue for some time as interest rates remain so low at the short end of the yield curve. More importantly, the potential loss of transactional stability at $1 if a floating NAV is adopted threatens to make money market funds less attractive as the safe haven of choice for certain classes of investors. However, against the backdrop of lackluster perfor- mance, regulatory amendments, and the prospect of additional reforms, we see a growing opportunity in the marketplace. Specifically, securities that today are just outside the limited money market universe, whether with respect to maturity or credit quality, offer more compelling yield opportunities with the potential for limited volatility. Prevailing steepness in the short-term yield curve The short end of the yield curve, generally defined as three years or shorter, offers a key point of opportu- nity for strategies that are willing to stand outside the more narrowly focused money market space. As money market funds since 2010 generally have been required to invest in shorter-term securities, some issuers of money market instruments have at the same time attempted to lessen their dependence on short-term funding. As a result, these institutions have been issuing longer-term debt outside the reach of money market funds with maturities longer than 13 months. While the overall absolute level of interest rates is low, the combination of a more restricted money