On October 14, 2016, the U.S. Securities and Exchange Commission (SEC) will begin enforcing regulations adopted to help reduce the risk of investor “runs” on money market mutual funds. Vulnerabilities in the $3.8 trillion market came to light during the 2008 financial crisis.1
Many individual investors may hardly notice when the new rules take effect. That’s because institutional investors are the primary target of the SEC regulations; they redeemed money fund shares at a much greater rate than individuals during the crisis.
This Q&A discusses the new regulations and some changes investors can expect to see in the money markets going forward.
What are money market funds and how do investors use them?
Millions of individuals, corporations, and municipalities rely on money market funds to help manage their cash. For example, investors often hold the proceeds of investment sales in a money fund until they are ready to reinvest the money. The funds invest in a variety of short-term debt securities, so there is typically little fluctuation in value and they can usually be liquidated easily.
There are several types of money market funds, each with different underlying investments. Prime funds invest in riskier short-term corporate debt. Tax-exempt (municipal) funds invest primarily in securities issued by state and local governments, and government funds must have 99.5% of total assets invested in cash, U.S. Treasury securities, other government securities, and repurchase agreements collateralized by government securities.
What led to the reform measures?
Money market funds have traditionally traded at a net asset value (NAV) of $1 per share, even though the underlying holdings might be worth slightly more or less. In the fall of 2008, a long-established institutional money fund “broke the buck” after suffering investment losses that caused its shares to fall to 97 cents. Investors fled from money market funds in a panic that threatened to freeze corporate lending markets. To help limit the damage, the federal government intervened by providing a temporary guarantee for all money market funds.2
How might the additional regulations affect investors?
Focus on institutions. The new SEC rules make a distinction between retail and institutional money market funds. Retail investors are defined as “natural persons,” such as individuals who can be identified by a Social Security number. Financial institutions, governments, defined benefit plans (pensions), corporations, endowments, and other accounts that are not owned by natural persons are allowed to invest only in institutional money market funds.
Floating NAV. The SEC rules require that institutional prime money market funds maintain a floating NAV for sales and redemptions rather than a $1.00 stable share price. This means their share prices will fluctuate with market changes like other mutual funds. Investors who pursue the higher yields of these funds will be expected to accept the additional risk. By contrast, government and retail money market funds will continue to trade at a stable $1 share price.
Fees and gates. All prime and tax-exempt money market funds (for institutional and retail investors) will be capable of placing restrictions on redemptions in times of stress. If weekly liquid assets fall below 10% of total assets, the fund’s board could impose a liquidity fee of up to 2% on shareholders who sell their shares. If weekly liquid assets fall below 30%, a “gate” could be used (in addition to fees) to prevent investors from withdrawing money altogether for as many as 10 business days in a 90-day period. Government money funds are not required to implement fees or gates.
How are institutions adapting?
Fund companies and institutions had two years to evaluate their cash management needs and prepare for the new regulations. Institutional investors that want to protect their principal at all costs, or can’t risk losing access to their money, have already started to shift assets away from prime money funds with floating NAVs and other nongovernment money funds that may be subject to fees and gates.3
Many fund companies are changing the names and/or investment composition of their money market funds so they are consistent with the investment guidelines. Many prime funds are converting to government funds, while others are increasing liquidity by shortening debt maturities, reducing the risk that fees and gates will be triggered in times of market volatility.4
What else should individual (retail) investors know?
Retail investors are less likely than institutions to feel the effects of reform. However, individuals who participate in 401(k) or other retirement plans could receive information from plan providers, if they haven’t already, explaining changes to money fund offerings and their options. Those who have specific questions about these regulatory changes or their own investments should contact their financial professional.
Money fund reforms were intended to end the perception of an implied government backstop, protect taxpayers from future bailouts, and strengthen the nation’s financial system. These relatively conservative investment vehicles can continue to play an important role in the portfolios of many individual and institutional investors, albeit with a more realistic view of the potential risks.
U.S. Treasury securities are guaranteed by the federal government as to the timely payment of principal and interest. Although money market funds seek to preserve the value of your investment at $1.00 per share, it is possible to lose money. Money market funds are neither insured nor guaranteed by the Federal Deposit Insurance Corporation (FDIC) or any other government agency. Institutional money market fund sponsors have no legal obligation to provide financial support to the money fund portfolio, and investors should not expect that the sponsor will provide financial support to the portfolio at any time.
Mutual funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus (or the official statement in the case of tax-exempt funds), which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
1-3) Investment Company Institute, 2015-2016
4) The Wall Street Journal, September 14, 2016