For many treasurers and their bosses, prime money-market funds have provided enough yield on investable cash during the past year and a half — enough while interest rates have been so low, that is. But as a result of new Securities and Exchange Commission rules for these funds, companies may now be paying an unnecessary liquidity premium, says Capital Advisors Group, an institutional-investment firm. That’s because the changed compositions of prime money funds due to the new rules could reduce the yield the funds earn.
After the height of the financial crisis and the blowup of the Primary Reserve Fund, money managers moved into shorter-term, more-conservative investments such as Treasury bills and time deposits of financial institutions. They had to ensure that in a crisis they could meet the same-day funds availability that money-market funds promise investors.
The SEC’s new 2a-7 rules, taking effect this year, make money funds even more liquid. Funds now have to hold 10% of their portfolios in instruments maturing overnight and 30% in investments maturing within 7 days. Their weighted average maturity (WAM) has to be 60 days or less, down from 90 days. All that may help prevent fund meltdowns in the next crisis, but what if a treasurer could construct a similar portfolio that was less liquid? Would the gain in return be meaningful?
Back in May, Capital Advisors estimated that U.S. prime money funds would “relinquish” about 8 basis points due to the SEC rule changes, based on historical money-market performance. The firm tested that hypothesis in June, taking into account the current low-yield environment. It found that extending the WAM of two hypothetical portfolios to 60 days and 120 days resulted in 11 basis points and 31 basis points of added yield, respectively, over a base-case portfolio with a 30-day WAM. (The base-case portfolio earned a 0.24% average yield.) The portfolios were modeled on 15 AAA-rated prime money funds and used the performance of publicly available bond indices in the month of June.
The message is simple: if a company doesn’t need overnight liquidity, it can increase returns by taking some funds out of money markets and putting them in a managed or self-directed account. In the models, “we’re not taking on a lesser-rated security to get a higher yield,” stresses Lance Pan, director of research for Capital Advisors. “Just extending the maturity gets you there.” For example, the only difference between the 30-day and 60-day model portfolios was the replacement of all overnight repurchase-agreement positions in the financial debt category with things like six-month certificates of deposit issued by AA-rated U.S. banks.
Still, there are caveats. The 120-day model portfolio, for example, leaves no liquidity buffer for unplanned needs, Capital Advisors says. It is a “supplemental yield-enhancing portfolio over and above a liquidity vehicle such as a money market fund,” says the report on the test. Still, the report continues, “interest rate risk remains modest in this portfolio, given the 180-day final maturities in securities and the market expectations of no Fed tightening in 2010.”
Pan stresses that “liquidity budgeting” in this manner is merely a complement to money-market funds, not a replacement. “This is a planned liquidity vehicle,” he says. “If you have a project [expenditure] coming due in 90 days, you buy something that matures in 90 days.” The downside is that if a company needs funds in an emergency, it may be forced to sell part of its portfolio before the maturity date — and it may have to do so at unfavorable prices. “You’re exposed to market fluctuations — that’s the main drawback of this strategy,” says Pan.