In October 2016, the U.S. Money Market Fund (MMF) industry changed dramatically with new requirements for U.S. institutional prime and institutional municipal MMFs becoming effective. In our opinion however, thanks to a carve-out for U.S. government and Treasury funds, the insurance-linked securities (ILS) markets needn’t lose sleep over these changes.
Under the new U.S. MMF regulations, institutional prime and institutional municipal MMFs are required to change from a fixed net asset value (NAV) to a floating NAV and adopt provisions to consider liquidity fees and redemption gates under certain circumstances. However, Government and Treasury MMFs were given a reprieve from these structural changes because of their perceived low risk and high liquidity – the exact reasons that many ILS investors have long chosen these funds as the investment vehicle of choice for cash collateral reinvestment.
While the structural changes did not impact U.S. Treasury and Government MMFs, the market experienced some changes, particularly with respect to supply and demand in this space. In the lead-up to the October implementation date of the new regulations, many investors chose to shift their cash investments away from U.S. prime institutional MMFs and into U.S. Government and Treasury MMFs. According to the Investment Company Institute, the Government and Treasury category of U.S. MMFs grew by over $1 trillion in the 12 months since October 2015.
The question remains, did these inflows have a material impact on the supply and demand dynamics of this category?
The inflows experienced by U.S. Treasury MMFs were unprecedented but in turn U.S. Treasury bill outstandings have also increased by approximately $175 billion (through the end of the third quarter 2016). This combination of increased U.S. Treasury bill supply together with higher tri-party repo balances and significant usage of the New York Federal Reserve Bank’s Reverse Repurchase Program facility by eligible counterparties has helped the market meet the need for increased supply and contributed to the short-term rates markets functioning relatively well in the lead-up to the regulatory changes.
The intense competition for short-dated government bonds and Treasury bills in the U.S. cash market has resulted in expensive valuations for the sector as the extra $1 trillion of cash in Government and Treasury MMFs seeks to invest in these instruments. However, while money market participants are currently enjoying higher Treasury bill supply for the first time in six years, this development may be short-lived. A significant Treasury bill supply squeeze could be looming ahead of the U.S. Federal government debt limit suspension period that ends on 15 March 2017. The anticipated reduction in the Treasury’s cash balance will likely force large declines in Treasury bill outstandings in the first quarter of 2017 and cause yields across the Treasury bill curve to decline. Yet the structural changes from U.S. MMF reforms have been so transformative that massive inflows into government money markets took place despite net yields that increasingly trailed those of prime funds for most of the year. So, we don’t expect this short-term development to impact the usage or risk profile of U.S. Government and Treasury MMFs as these reforms are a permanent reality and supportive of higher investor sponsorship.
An interesting phenomenon as a result of the shift in MMF flows from Prime to U.S. Government and Treasury MMFs is the spike in the London Interbank Overnight Rate (LIBOR). As of 30 October 2016, the spread from LIBOR to Treasury bill was at its widest level since the financial crisis. In our opinion, this spread will remain higher than its historical norm. This should not affect the attractiveness of U.S. Government and Treasury MMFs but may raise the question for some investors of the relative attractiveness of variable NAV Prime funds going forward.
Some ILS investors have historically used Non-U.S.-domiciled MMFs and these were also not directly impacted by the recent regulatory changes. Many Prime and Treasury Offshore MMFs continue to be constant NAV vehicles and thus continue to be priced at $1.00.
However, despite the availability of these offshore MMFs, many offshore and onshore ILS investors prefer to use U.S. domiciled MMFs. Historically, non-U.S. investors in U.S. domiciled MMFs have been subject to a 30% withholding tax on distributions received. On 18 December 2015, the Protecting Americans from Tax Hikes Act of 2015 (the “PATH Act”) was signed into law. The PATH Act made permanent the withholding tax exemption applicable to qualified interest income distributions paid by onshore funds, QII. Therefore, non-U.S. investors are no longer subject to withholding tax on distributions received from funds whose earnings are made up solely of U.S. source income thus making U.S. MMFs highly attractive to non-U.S. investors.
In summary, recently adopted changes to U.S. MMFs were transformative for certain types of MMFs. However, users of U.S. Government and Treasury MMFs, such as ILS investors, were largely insulated from these reforms. For ILS investors seeking to invest cash collateral, U.S. Government and Treasury MMFs remain a viable option as a lower-risk, highly-liquid investment vehicle.
FOR INSTITUTIONAL / PROFESSIONAL CLIENTS & QUALIFIED INVESTORS
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