COVID-19 has presented numerous challenges for money market funds (MMFs), challenges that have really tested their resilience. Common questions investors are asking us include: are MMFs still a viable option for your cash, even during these unprecedented market conditions? Also, do they still deliver capital preservation, daily liquidity and yield?
The global financial crisis and the eurozone sovereign debt crisis led to an overhaul of regulation across banks, insurance companies, repo markets and MMFs. The January 2019 European Money Market Fund Reform followed similar regulations of the US Money Market Fund Reform in 2016.
As a recap, the regulations were designed to ensure short-term MMFs would be well-positioned to withstand another crisis – ie they would continue to function during times of extreme stress and cope with abnormally large redemptions. Aviva both contributed to, and lobbied for, these changes. They represent a total reform of the industry and a new type of fund was created – a low volatility net asset value (LVNAV) fund.
The regulations are too comprehensive to cover here, but here are a few key points:
Liquidity
Around the middle of March, as the pandemic took hold throughout Europe and the US, it became apparent that more serious and unprecedented measures would be needed to contain the virus. Lockdowns, store and school closures, national border closings and airline fleet groundings became normal. This severe and sudden stalling of the global economy created market volatility, with some of the largest consecutive daily drops in equity markets we have ever seen. There were large redemptions from all asset classes, which led to fire sales as investors flocked to safe havens. Liquidity diminished and central banks acted swiftly around the globe by cutting rates and injecting liquidity back into the markets. Having learnt from the lessons of the last crisis – ie that fast and drastic action is essential – central banks made it clear that they would take all necessary action to support financial markets.
MMFs were not immune from this sell-off. Liquidity dried up in the assets that both MMFs and treasurers purchase for short-term investment purposes. US MMFs saw large movements in assets under management, as investors withdrew cash from MMFs back to bank accounts as a perceived safe haven. Though not a crisis anyone was expecting, MMFs were able to perform their key role of providing liquidity. This was done by repositioning their own, already high levels of liquidity, which in turn decreased demand for longer-term paper. To ensure continued confidence in USD funds, the Fed also announced support for MMFs. Some euro and sterling funds also experienced outflows.
This unprecedented event tested the money market industry to its extremes. So far, it is encouraging to see that the new regulations appear to have ensured that the industry met its obligations during this volatile period. You could view it as a real-life stress test. Not only did funds meet the need for cash from their clients, but they were also able to enhance their short-term liquidity by 30-50%, proving that MMFs are agile and able to adapt quickly to stresses in the markets when required.
Capital preservation
Crucially, MMFs continue to provide more diversification than bank deposits: the benefits of not placing all your eggs in one basket can be amplified during a crisis. There will be winners and losers from this crisis.
It is here that strict regulatory criteria over the credit quality assessment of the underlying issuer should come into effect. MMFs invest in very highly rated assets: AAA-rated funds have additional restrictions requiring high proportions of AAA- and AA-rated assets in the portfolio, with low exposure to A-rated issuers that have long maturities (beyond six months). The regulations also refer to a diversification framework that stipulates maximum allocations at not only an issuer level, but a product level, too.
In practice, for investments beyond a one-day maturity in our prime funds we target a maximum exposure to each issuer well inside the regulatory cap of 5% of NAV. During an evaluation of negative rating action, we also stress the portfolios for a two-notch downgrade of the underlying issuers, reduce the weighted average maturity and life (WAM and WAL) of the portfolio and ramp up liquidity. This is done while still providing all the diversification benefits of a pooled fund. Therefore, to ensure capital preservation, MMFs can adapt their portfolios quickly and efficiently.
Yield
Although yield is a secondary consideration both for money managers and investors when market conditions are volatile, MMFs can deliver yield. During the wave of COVID-19-induced central bank rate cuts across the globe, MMFs held on to higher yields for longer by taking the weighted-average duration of the portfolios out to 60 days.
The current steep and upward-sloping yield curve makes overnight rates look particularly unattractive. This is not due to any increased risk of default for issuers MMFs invest in, but due to an increase in term and liquidity premium. MMFs tend to be highly invested in banks, which the then governor (Mervyn King) of the Bank of England said would not be the cause of the next crisis, but the solution. Banks are now well capitalised as a consequence of the post-global financial crisis regulation and the central banks have used them to not only inject liquidity into the market, but also to support the real economy. This benefits MMFs as clients can obtain more attractive yields than a bank deposit during a time of unexpected interest-rate cuts.
Technology has enabled us all to adapt and deliver a seamless transition for clients. Group video calling is the new norm and essential in a fast-changing market. This applies both to internal communication between investment desks, as well as for dialogue with clients. By leveraging technology, we are able to keep clients comfortable with our overall strategy and relay notable changes quickly and efficiently. This enhanced two-way conversation also allows for better transparency of future cash requirements to aid effective portfolio management.
Government funds have been in demand. In the US, clients are more agile in moving from prime MMFs to government funds – as evidenced by the large migration in 2016 when US reforms were implemented. Demand for our Government Liquidity Fund (GBP) has increased, indicating the importance of these funds as investors using bank deposits seek alternative ways of finding safety.
Although it is too early to make any lasting conclusions, so far MMFs have navigated their way through this crisis successfully, delivering capital preservation, liquidity and yield. In large part, this is down to the enhanced regulations implemented in recent years that require high degrees of liquidity to manage volatile markets. One thing we can be sure of, they will continue to provide an essential tool for investment and liquidity management.
Tony Callcott is global head of liquidity sales; and Caroline Hedges is global head of liquidity portfolio management at Aviva Investors.
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This article was taken from the June/July 2020 issue of The Treasurer magazine.
