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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.

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Putnam Perspective: Money market (in)eligible

  1. 1. PUTNAM INVESTMENTS  | 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 2014 » White 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. 2. PUTNAM INVESTMENTS  | 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 SEC’s Commissioners would not support the SEC staff’s 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 fund’s weekly liquidity fell below 15% of its total assets, assuming a fund’s board of directors finds that such fees do not run counter to the best interests of the fund’s shareholders. In addition, the fund could be “gated,” effectively putting a temporary halt to all redemption activity for a 30-day period unless the fund’s 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 today’s 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: Figure 1. Money market fund timeline First money market fund established The buck breaks at Reserve Primary Fund in the wake of systemic financial market stress FSOC recommends alternatives for money market reform, including a floating 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. 3. PUTNAM INVESTMENTS  | 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 market universe and the changing supply dynamics has produced a steep short-term credit yield curve. This means that the overall yields for short-term instruments move dramatically higher just outside of the money market universe. For instance, as of September 25, 2013, there was roughly a 52-basis-point spread between overnight investments and one-year LIBOR. For this reason, we believe that investing conservatively but just outside of Rule 2a-7 can enable investors to add yield to a portfolio — with limited downside risk. Slightly lower credit quality Money market funds have always concentrated in AAA-rated and AA-rated securities, as the limitations for any investments in lower quality are quite stringent. Typically, A-rated and BBB-rated securities receive less attention from money fund managers. One primary difference in the money market universe of AAA-rated and AA-rated securities was not created by changes in SEC regulation. As a consequence of the credit crisis, rating agencies tightened their methodologies for rating domestic banking institutions, which resulted in the downgrade of many of the large banks that formerly were significant issuers of money-market-eligible secu- rities. Because of the downgrades, while many remain investment grade, these securities are no longer eligible for purchase by money market funds. Shining a light on the shadow NAV It is commonly known that money market funds have a $1 NAV, the price at which money market fund shares are generally transacted. But it is less widely known that money market funds also have a “shadow,” or mark-to-market NAV, which reflects fluctuations in the value of a fund’s assets. While fund managers have been disclosing their shadow NAV to the SEC on a monthly basis since 2010 — and with a 60-day lag to the public — some firms have recently begun to highlight this data on a more frequent basis. Heightened transparency, these firms may hope, will show how marginal the difference between the stable $1 NAV and the shadow NAV typically is — e.g., only fractions of a penny — and thereby demonstrate the lack of a need to adopt a “floating” NAV. The SEC’s June 2013 proposal includes enhanced disclosure, as well. The SEC’s June 2013 proposal for a floating NAV, also articulated by the SEC in June 2013, could abolish the dual-NAV structure, requiring that insti- tutional investors transact in shares whose value would fluctuate on a daily basis. Industry critics have expressed concerns that this requirement would undermine investor confidence in money market instruments and lead to higher volatility.
  4. 4. PUTNAM INVESTMENTS  | 4 FEBRUARY 2014  |  Money market (in)eligible: An update on reform and emerging opportunities These investment-grade securities rated A and BBB represent opportunity for additional yield. The same issuers with slightly lower ratings still represent attrac- tive credit risk. Again, an investment strategy that stands outside money market boundaries can access these securities, which frequently may have up to three- year maturities, with relative ease and at potentially attractive terms. Furthermore, when these securities roll closer to maturity, they may experience pronounced spread tightening, which underscores the opportunity in these issues. In contrast to ultra-short bond funds While there has traditionally been a competitive universe category for both money market and ultra- short bond funds, the opportunity created in today’s market falls somewhere between the two. Though it cannot be valued at a static $1 NAV, a portfolio invested in this “in between” space is able to take advantage of the steep yield curve and the slightly lower-quality investments available just outside the Rule 2a-7 money market universe but without taking as much risk as a typical ultra-short bond fund. While the ultra-short competitive space is varied, as is common in many competitive categories, a significant number of these funds utilize currency exposure and invest in below-investment-grade, or high-yield, securi- ties. Both of these strategies may add yield, but extra yield does not come without commensurate additional risk. Currency exposures and high-yield debt may add greater volatility and will add greater credit risk to any fund investing in these securities. We believe there is room in between the very conservative money market space and the riskier ultra-short space — in other words, an opportunity to create vehicles with lower volatility than exhibited by many ultra-short bond funds but that create just a bit more yield for conservative investors. Figure 2. Yield curve steepness of a sample issuer 1 month 3 months 6 months 1 year 2 years 3 years 0.0 0.2 0.4 0.6 0.8 1.0 (%)1.2 Anheuser-Busch U.S. Treasury curve Typical money market fund Putnam Short Duration Income Fund Sources: Putnam Investments; Bloomberg. Past performance is not indicative of future results.
  5. 5. FEBRUARY 2014  |  Money market (in)eligible: An update on reform and emerging opportunities Putnam Retail Management | One Post Office Square | Boston, MA 02109 | 285713 2/14 The views and opinions expressed are those of the speaker Joanne M. Driscoll, CFA, Portfolio Manager, Putnam Investments, and Jo Anne Ferullo, CFA, Investment Director, Putnam Investments, as of December 31, 2013, are subject to change with market conditions, and are not meant as investment advice. Consider these risks before investing: Putnam Short Duration Income Fund is not a money market fund. The effects of inflation may erode the value of your investment over time. Funds that invest in government securities are not guaranteed. Mortgage-backed securities are subject to prepayment risk and the risk that they may increase in value less when interest rates decline and decline in value more when interest rates rise. We may have to invest the proceeds from prepaid investments in other investments with less attractive terms and yields. Bond investments are subject to interest-rate risk (the risk of bond prices falling if interest rates rise) and credit risk (the risk of an issuer defaulting on interest or principal payments). Interest-rate risk is greater for longer-term bonds, and credit risk is greater for below-investment-grade bonds. Risks associated with derivatives include increased investment exposure (which may be considered leverage) and, in the case of over-the-counter instruments, the potential inability to terminate or sell derivatives positions and the potential failure of the other party to the instrument to meet its obligations. Unlike bonds, funds that invest in bonds have fees and expenses. Bond prices may fall or fail to rise over time for several reasons, including general financial market conditions and factors related to a specific issuer or industry. You can lose money by investing in the fund. Request a prospectus, or a summary prospectus if available, from your financial representative or by calling Putnam at 1-800-225-1581. The prospectus includes investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing.