Corporate Treasury: Year End Rates and Fixed Income Positioning

Until the week of December 3rd 2018 the financial press and the majority of financial professionals were convinced that interest rates would continue to rise and that the Fed would continue steady tightening until the Fed Funds rate reached between 3.00-3.50%. We continue to believe the Fed will stick to their current course of tightening when they meet later this month by raising the Fed Funds rate another 25 bps. At Copper River, we have long believed that the Fed will hit the pause button on the tightening cycle sooner than many expect and we still have that view.

Of interest is how much the yield curve has flattened over the past several weeks. On December 5th the spread between two-year treasury bonds and 10-year treasury bonds is 11 basis points. It is important to remember that the Fed doesn’t set rates outside the curve, they only set the Fed Funds rate. At the long end of the yield curve, rates are determined by inflation expectations and the supply/demand equation of how much issuance is hitting the market versus investors’ appetites for long-dated bonds. Inflation has been running well below its historical pace compared to where it’s been at this point in the cycle and when levels of unemployment are this low. In particular, wage inflation is approximately 1% below its rate when we were last at or below 4% unemployment. There are plenty of reasons for this and none are particularly transitory. Put a different way, long-term inflation expectations are relatively low and are unlikely to rise much this cycle. We might see core inflation numbers rise slightly from here, but even a 2.5% core inflation rate seems like a stretch.

As for the supply/demand balance there is a lot more uncertainty. We know that Treasury supply will be increasing dramatically over the next couple of years due to lower tax revenue and increased government spending. It’s far more difficult, however, to forecast what the demand for bonds will be. Foreign demand, in particular, remains robust thus far as the nominal rates on Treasuries (and high-grade credits for that matter) are much higher than what can be purchased in other G7 countries’ home markets.

If we assume that demand remains sufficiently strong, given that inflation is expected to remain subdued, we will not see much pressure on long rates. With the Fed intent on continuing to “normalize” policy, this results in the very real possibility of a flat, if not slightly inverted, yield curve (we saw spots of inversion on 12/4 and expect it to be a continued theme), with all Treasury rates in the 3.00%-3.50% range.

While rates and prices in the global fixed income markets are volatile and unpredictable, we have seen an increased demand for buy and hold bond portfolios. The primary interest and the best solution for corporate treasury has been laddered treasury bond portfolios, with properly managed duration. These portfolio meet the objectives of safety, liquidity and yield more so than any other options in the marketplace. The partners at Copper River have decades of experience in the fixed income markets and are happy to have one on one discussions about private bond portfolios and/or the subject matter discussed above.

Money Market Funds. What the industry has not, and will not, discuss with you. A deeper look from two who worked inside the industry

Over the past few years, much has been analyzed, discussed, and written about the SEC Money Market (MMF) reforms that went into effect in the fall of 2016. For those unaware, here is a good link highlighting the summary of the reforms written by Morgan Stanley, along with an easy to understand detailed breakdown on page two.

The new SEC rules regarding MMF’s were passed quite some time ago (2010 and 2014), with the requirement for managers to fully implement the changes by 2017.

Despite these rules being now fully in effect, a stream of dissension and misinformation about these rules has found its way in the public marketplace. The dissension almost always focuses on two basic themes. One, that the SEC, as well as the Federal Reserve, overstepped their role in passing the new rules. Two, that the effects of the new rules have caused harm to investors, credit markets and the financial system as a whole. The readers of this continuous “sky is falling” MMF narrative need to be aware that the sources of these press releases, white papers and analysis  are almost always coming from either the fund managers or MMF platforms. These managers and platforms have lost considerable assets, and are struggling to recapture the revenue stream lost as a result of these changes. A Forbes article titled “Fidelity, Federated Lead Charge Against Money Fund Reform” highlights just what is at stake for the industry.

While the MMF reforms implemented were extensive, the SEC was certainly thorough in their research of the funds over past decades, and was thoughtful in crafting the new rule changes. All the research, proposals and fine print on the final changes can be found on the SEC site for MMF’s.

HERE ARE SOME OF THE FACTS THE Money Fund INDUSTRY WILL NEVER DISCUSS WITH YOU

Reserve MMF Fund Fails (2008)- Following the collapse of Lehman Brothers in 2008, the Reserve Primary Fund, the nation’s oldest money market fund, held $785 million in Lehman Brothers debt on the day Lehman went bankrupt.

Over the next two days, the $62 billion fund faced $40 billion in redemption requests. The fund “broke the buck” and investors spent years attempting get their money back.

Investors Rush the Gates– During the week of September 15, 2008, investors withdrew some $310 billion (or 15%) of assets from prime money market funds. A rush to the exit for shareholders of the MMFs created systemic financial stress on the entire industry. This article from the New York Times Post-Lehman,Money Market Fund Protections Still Weak explains the situation in the market at time of the mass redemptions.

US Government Bailout of MMF Industry– Sept 30. 2009. the Treasury Department backstopped US MMF industry to prevent further fund failures. Government Bailout of the industry takes place.

RESERVE FUND NOT THE ONLY FUND TO FAIL- “31” Money Funds FAILED

According to in-depth research done by the Federal Reserve, “The Stability of Prime Money Market Mutual Funds: Sponsor Support from 2007 to 2011“, a different picture of the fragility of Money Funds under times of stress emerges. The Federal Reserve has the responsibility to provide the nation with a safer, more flexible, and more stable monetary and financial system. Here is a quote from the articles summary page:

“This paper presents a detailed view of the non-contractual support provided to MMMFs by their sponsors during the recent financial crisis based on an in depth review of public MMMF annual SEC financial statement filings (form N-CSR) with fiscal year-end dates falling between 2007 and 2011. According to our conservative interpretation of this data, we find that at least 21 prime MMMFs would have broken the buck absent a single identified support instance during the most recent financial crisis. Further, we identify repeat instances of support (or significant outflows) for some MMMFs during this period such that a total of at least 31 prime MMMFs would have broken the buck when considering the entirety of support activity over the full period.”

FURTHER ANALYSIS OF THE MANAGERS PROPPING UP AND SUPPORTING THEIR OWN MMF’S OVER THE YEARS

We quote again from the Federal Reserve Risk and Policy Analysis Unit:

“The data suggest that during the period from 2007 to 2011, sponsor support was frequent and significant to many of the supported funds. Direct support alone totaled at least $4.4 billion, provided to at least 78 of the 341 funds reviewed. Support for these 78 funds occurred in 123 instances with 32 funds receiving support in multiple reporting periods. “

Please see specific support by individual MMF sponsors in the chart below:

WHAT NEW RISKS SHOULD CORPORATE TREASURERS CONSIDER AS THEY EXAMINE WHERE TO INVEST CORE AND OPERATING CASH?

Prime Funds– “Gates and Fees”. Despite the industry for years telling institutional investors that Prime Funds will continue on and with a solid investor base the truth is the money fund rule changes were a death sentence to the product. As of 2017 over1 trillion of assets have left Prime Funds.

Treasury and Government Funds– The recipient of most of the Prime Fund defections, but investors should be aware that MMF Boards may choose to impose “Gates and Fees” upon times of stress. Given the criticism and overhaul of mutual fund boards after the last financial crisis, one would assume these boards will be much more active and inclined to use their executive mandates during the next time of extreme market stress.

MMF Portals– Risks present in “Omnibus Settlement” and “Broker-Cleared” transactions should be reviewed and understood by investors. Additional new concerns such as Cyber Security threats should be understood and examined for web based transactional platforms. A breach of your web or cloud based investment portal could in turn make your enterprise’s network vulnerable to hackers.

 

 

About Scott and Jim

Scott Fox and Jim Etten both worked inside the institutional asset management business from 2005 to 2012. Their view and experience is unique due to the fact that they worked with fund companies and in the portal industry. The misinformation that was prevalent in the markets and from the industry led them to create Copper River Advisors in order to work in an open architecture model as an RIA firm and in a fiduciary role for their clients.

Key Findings from the 2017 J.P. Morgan Investment Peerview

Investment in money market funds still strong

Based on the market outlook for next year, over 60% of respondents will continue with the same allocation to money market funds, while 22% will increase their allocations to stable NAV funds and 20% to floating NAV funds. Money market funds and bank obligations account for the majority of cash balance allocation. Nearly 40% of respondents cited money market funds as their chosen vehicle for money moved off a bank balance sheet—by far the most popular placement.

Regulatory pressures

In many ways, the regulatory arena has been transformed since our last survey, in 2015. Respondents are grappling with the implementation of money market reform in the U.S. and the approach of reform in Europe, as well as the efects of Basel III around the globe. In Europe, 44% of respondents said they need more time and/or information before they decide on their preferred money market fund structure. Among those considering new structures, 43% ranked risk of gating or a liquidity fee as the most important factor in their decision-making process.

Investment policy changes

More respondents are updating their investment policies to ensure that they provide the fexibility needed in the new rate and regulatory environment. Notably, 48% of respondent policies now permit FNAV funds, up from 32% in 2015. Nearly a third of respondents are looking to add FNAV funds to their list of allowable investments. Changing an investment policy is rarely a simple undertaking. More than three-quarters of respondents said it would take a moderate or signifcant efort to implement a change—suggesting that planning should begin well in advance.

Shifting rate environment, search for yield

In a still-low rate environment, investors continue to search for yield and reassess their appetite for risk. Nearly two-thirds of respondents said they would select money market funds for their cash investments if bank deposit rates lag. As they evaluate the impact of negative interest rates on euro—and/or sterling—denominated instruments, a large majority of respondents are considering policy changes to allow increased credit risk, more interest rate risk and the use of currency swaps.

Keener need for cash segmentation

Liquidity investors are re-evaluating their investment strategies to meet the demands—and seize the opportunities—of an evolving rate and regulatory environment. Many respondents have determined that they need to consider new investment solutions, including foating NAV funds and more customized portfolios. Cash segmentation—categorizing cash by liquidity needs—is often a key component of the re-evaluation process. More than 70% of respondents can forecast their cash fows out for a month or longer. Just under half can forecast out a quarter or longer.

Moving back into prime funds

Only 37% of U.S.-based respondents are currently invested in a prime money market fund, down from 63% in 2015. A majority transitioned assets to a government money market fund in the wake of new SEC 2a-7 rules. Fifty percent of U.S. investors who transitioned assets from a prime to a government MMF cited comfort level with foating NAV and gates/fees as the primary factor in reconsidering prime. Among respondents who transitioned assets out of prime MMFs, nearly half would consider moving back if prime ofered an excess yield of between 15 basis points and 50 basis points.

—Read the full report from JP Morgan here

Money Market Reform and the Opportunity for Enhanced Cash ETFs

Overall US listed ETF net inflows totaled $93.1 billion in Q3, accelerating significantly from $34.2 billion in net inflows in the previous quarter. The strongest category for net asset flows was US Equity ETFs, with $45.6 billion in net inflows in Q3, compared to $12 billion in net inflows in Q2. – Ryan Issakainen

Read full article on Nasdaq.com