Regulations designed to safeguard the $2.7 trillion U.S. money-market industry threaten to steer cash toward higher-risk alternatives.
Investors may respond to the market overhaul that took effect last week by seeking the higher yields of short-term bond funds, say Crane Data, Fitch Ratings and Goldman Sachs Asset Management. In a sign of the segment's appeal, a category that Crane dubs conservative ultra-short bond funds, with maturities mostly less than one year, has swelled to a 19-month high of almost $31 billion.
But these funds aren't subject to the same standardization as their money-market counterparts, raising the prospect that investors will be surprised by the degree of potential losses and even run for the exits if values slide. That may undermine some of the benefits from the money-fund revamp, which most firms agree has gone a long way to reducing systemic risks in an industry that helped fuel the financial crisis.
“The risk has shifted, and we don't know yet where else investors may take on risk and whether it's appropriate or not,” said Christina Kopec, head of product management at Goldman Sachs Asset Management, which oversees about $1.1 trillion, including money funds and short-term bond funds. People may seek alternatives, such as “a bond fund, because they are just so frustrated by yield, but potentially underestimate the risk they are taking.”
Investors have already shuffled $1 trillion into lower-yielding money funds as a result of the new Securities and Exchange Commission rules. A pillar of the transformation is that share values now float for institutional prime money funds, which buy riskier, non-government debt. That means holders can suffer losses in an industry seen for decades as a safe parking spot. Government-only money funds, which invest in Treasury bills and other short-term U.S. debt, are exempt from the changes and have lured cash amid the exodus from prime funds.
Yet the uninspiring returns on government-only funds may lead investors to seek another destination. The 30-day yield for those offerings, an annualized measure of the period's earnings, was about 0.17% as of Oct. 17, compared with a yield of 0.81% for Crane's conservative ultra-short bond-fund index. Prime institutional funds yield 0.29% on average
For Peter Crane, president of Westborough, Mass.-based Crane Data, the risk is that investors lured to short-term bond funds for their relatively higher yield may flee if they see share values slump, as holders of prime funds did in 2008, spurring a broader market disruption.
“Investors still haven't been taught the lesson that higher yield or higher return means higher risk,” he said. “We've seen this movie before, and every other time in history it ended badly.”
Short-term bond funds have already gained traction, partly as a result of growing expectations that the Federal Reserve will raise interest rates by year-end. These funds are deemed less risky than longer maturities when rates rise because they have a lower duration, meaning their prices fall less as yields climb.
Ultra-short bond funds have added $2.6 billion since July 31, after a cumulative outflow of $900 million in the first seven months of the year, according to data compiled by Bloomberg.
New Entry
Morgan Stanley's Institutional Fund Trust Ultra-Short Income Portfolio, the only new offering this year in Crane's conservative ultra-short funds category, has lured $711 million since its introduction in April.
Lauren Bellmare, a Morgan Stanley spokeswoman, declined to comment on the fund. In a note on its website detailing the offering, the firm says “a conservative ultra-short bond fund offers a compelling strategy that seeks to deliver current income while maintaining a focus on preserving capital and liquidity.”
Fitch warned investors in an Oct. 10 note to look before they leap into short-term bond funds from money-market offerings, because yields on the former are higher for a reason.
One advantage of the bond alternatives is that they don't subject investors to some of the unappealing new restrictions on prime money funds, including measures to slow client outflows during times of stress. But they entail other risks that money-fund investors traditionally haven't had to consider — such as the potential for losses when interest rates rise.
“These ultra-short funds are all very different and there is not even a clear definition of what a short-term bond fund is,” Gregory Fayvilevich, a Fitch analyst, said in an interview. “Investors are used to money funds being very tightly regulated and clearly defined by the SEC rules of what they can and can't do.”
Pacific Investment Management Co., which oversees about $1.6 trillion, is among companies benefiting from demand for short-term bond funds. Assets in its Short Asset Investment Fund have doubled this year to $1.1 billion.
Yet Jerome Schneider, the firm's head of short-term portfolio management, said investors must consider funds' track record in addition to things like yield differentials.
“Folks might reach for yield; folks might reach for income; they might reach for credit,” he said. “But risk shouldn't be taken blindly. It shouldn't be taken blindly in a prime money fund that is taking credit risk, and definitely not in anything that is further out the curve, including ultra-short funds.”
Bloomberg News
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