State of play in the short-term fixed income markets

FOR INSTITUTIONAL INVESTORS ONLY. NOT FOR PUBLIC DISTRIBUTION.

State of play in the short
-
term fixed income markets

Demystifying regulatory reform, interpreting implications and offering solutions

FOR INSTITUTIONAL INVESTORS ONLY. NOT FOR PUBLIC DISTRIBUTION.

Contents


Reform update


Market, issuer and portfolio implications


Client implications


1

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2

Reform update

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Current industry climate

3

I believe additional steps should be taken to address the structural
features that make money market funds vulnerable to runs.

Mary Schapiro

Chairman, SEC

“

”

A debate is on in the money market fund industry concerning the need for
additional regulatory reforms.

It’s disappointing that the success of the 2010 amendments is
ignored in pursuit of changes that will compromise core features

of money market funds.

Paul Stevens

President, Investment Company Institute

“

”

Money market funds play a critical role in the U.S. economy.

David Hirschmann

U.S. Chamber of Commerce

”

“

Europe doesn’t have any (money market funds),

and they have a financial system.

Ben Bernanke

Chairman, Federal Reserve

”

“

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How strong are money market funds today?

Still, the SEC is proposing additional regulations with varying impact on systemic risk.

4

Source: Investment Company Institute

Money market funds have shown great resiliency since significant reforms
were enacted in 2010.

Prime Money Market Funds accommodated large outflows during
U.S. debt ceiling and Eurozone debt crises

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The current regulatory environment

5

Regulators, think
-
tanks and industry organizations are working on a wide
range of potential solutions.

Split retail from

institutional

Split credit from

government funds

Structural

change

Two
-
tier regulatory
system

Status quo

Mandatory redemptions

in kind

Redemption fee

Escrowed shares

Gating

provisions

Sponsor capital

Shareholder funded

Subordinated share class

Capital

ideas

Minimal risk of impact to short
-
term markets while addressing
systemic risk concerns?

Floating NAV

With revisions to current

2a
-
7 rules

Unresolved systemic risk
in the market?

Implications for the

short
-
term markets?

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Potential SEC money market fund reform


SEC writing proposal
—

expected April
–

May


Two commissioners oppose additional reforms
—

one undecided

–
Commissioner Aguilar on the fence

–
3 votes of 5 needed to pass proposal

–
Potentially get 90
–

120 days to comment


Industry and investors
—

“Rare Alignment”

6

Proposed

money market fund reforms

Capital

Redemption

fee/holdback

Floating

NAV

Require money

market funds to hold capital
against a loss in market value.

Require

funds to charge a transaction fee for redemptions.
Potentially 5% of a client’s redemption would be held for 30
days. The 5% would be used as a first loss buffer in the event

a money market fund breaks the buck.

Convert money market

funds to floating

NAV

structure.

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Capital buffers

7

This proposal requires funds to maintain dedicated capital for covering losses
in times of trouble.

SEC position:

A capital buffer, in combination with the holdback proposal, would mitigate the incentive
for investors to run since there would be capital to address potential losses.

Capital buffer

Redemption holdback

Resources to address
significant falls

in a fund’s value

+

=

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Redemption restrictions

8

This proposal requires funds to hold back a percentage of a shareholder’s
redemption proceeds for a set period of time.

SEC position:

Discourages a run on the fund as shareholders redeeming the full amount of their
investment would bear the first loss in the event that a fund broke the dollar.

Example:
(Assumes a 5% holdback)

Investor owns
shares worth
$100

and redeems entire
amount

Receives

$95

today

Receives
remaining

$5

in 30 days…

…UNLESS a crisis
happens, in which
case the first
losses would be
funded by the
fund’s capital buffer
and then by that
$5

holdback

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Floating the NAV

SEC position:

A floating NAV reflects a fund’s true market value, demonstrates that money market funds
are not free from risk and helps reduce large redemptions during periods of financial stress.

9

This proposal requires funds to stop using the amortized cost method of
valuation and let their share prices float.

A historic look at market NAV fluctuations, 2000
–

2010

Prime money market funds

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10

Market, issuer and portfolio implications

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Market Implications


Restructuring of intermediation in the short
-
term fixed income markets


AUM shift to offshore MMFs, LGIPs, STIFs and short/ultra
-
short bond funds

–
Transfer of systemic risk from one market segment to another


Yield curve implications unclear

–
shift to Tsy/Govt sector would pressure curves lower

–
demand for shorter, liquid credit product would steepen the credit curve beyond 3 months


Dodd
-
Frank and Basel III
–

supply challenges


Shift to bank deposits. Wholesale deposits neither desirable, nor economical for banks and FDIC insurance
on non
-
interest bearing accounts may not extend past 2012

–
deposit fees?

–
funding shift to the Fed?




11

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Market Implications

12

Is bank deposit growth sustainable?

Source: BofA Merrill Lynch Global Research, Haver, Federal Reserve

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Market Implications

13

Banks unlikely to invest excess liquidity at current market levels

Source: BofA Merrill Lynch Global Research

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Issuer Implications

14

MMFs are a vital source of short
-
term funding to a variety of issuers

Sources: Investment Company Institute, Federal Reserve Board, U.S. Treasury Department, Fannie Mae, Freddie Mac, Federal Hous
ing

Finance Agency,
Federal Reserve Bank of New York, Municipal Securities Rulemaking Board, Municipal Market Advisors

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Issuer Implications

15

Systemic risk reduced as short
-
term funding markets have contracted

*Data for 2010 are through October.

Sources: Investment Company Institute and Federal Reserve Board

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Portfolio Implications

16

Floating NAV

Capital Buffer

Redemption Restrictions

Common Themes


Shorter WAM and WALs
–

first mover liquidity risks


NAV “arb” liquidity risks


Pricing considerations
–

premium on most liquid and easily
-

priced securities. Avoiding pricing “surprises”.


Increased levels of Tsy/Gov’t holdings in credit MMFs


Credit decisions become more conservative. Credit specific

stress => NAV and cash flow implications



Unique liquidity considerations: how to account for and

Manage the “hold back”. An additional liquidity requirement.



Sponsors with deeper capital resources attract a greater share

of industry AUM. Consolidation drives supply challenges.


Greater flexibility in regulatory framework if capital exists?


Consolidation impact on market liquidity. More concentrated

buyer bases.


Existing supply challenges exacerbated. Demand for shorter,

less volatile assets will not be met with issuer supply.


Shorter, more liquid and less credit
-
sensitive portfolios


More opportunity to add value in SMA structures?



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17

Client implications

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Corporate reactions

18

We rely upon the convenience and simplicity that the stable NAV
provides for accounting, recordkeeping and tax treatment of cash
balances.

New Jersey Association of Counties

“

”

Investors and issuers of money market funds express concerns about the
potential reforms.

Money market mutual funds are a reliable source of direct,
short
-
term financing for millions of businesses, non
-
profits,
and others, including colleges and universities.

American Association of State Colleges and Universities


”

“

Holding back a portion of an investor’s money to guard
against changes in share value would drive investment away
from the funds.

The Pennsylvania League of Cities and Municipalities


”

“

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Capital Buffers

19


A capital reserve is an interesting idea, but there are limits on the amount of
capital that could be raised.

Key considerations

Implications


A buffer can absorb limited losses


It cannot guarantee that a fund will not
break the dollar


Key questions remain: how much capital
is needed, and who will fund it?


Near
-
zero interest rates make
accumulating capital challenging for
shareholders


Requiring funds to raise the capital would
raises costs and lower returns



Higher costs, lower returns

-
Requiring a capital buffer would almost certainly
lead to lower returns on money market funds


Limited protection

-
A capital buffer would limit the actual protection
to investors from a fund breaking the dollar but
WOULD give them a false sense of protection


Investment policy impact

-
The implementation of capital buffers may
require changes to your investment policy


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Redemption Restrictions

20

This proposal eliminates the very attribute investors value most in a money
market fund
–

daily liquidity.


Key considerations

Implications


Changes the very nature, utility and value
of money market funds


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牥摥敭r浯牥m煵qckly


Discourages the use of money market
funds in a wide range of transactions


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i湶敳瑯牳⁲敬y 潮


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
䱯ss映摡ilyi煵i摩瑹

-
Investors

will no longer be able to redeem
their shares in full each day


More arduous recordkeeping

-
A holdback

position would eliminate the
current accounting simplicity of money
market funds


Investment

policy impact

-
With

many corporate investment policies
detailing liquidity requirements, investors
may be less willing or unable to invest


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Floating the NAV

21

Investment Policy Impact

This proposal eliminates the very attribute investors value most in a money
market fund
—

a constant NAV.

Key considerations

Implications


History shows that floating NAV funds

are not immune to redemption pressure


Many investors are unable or unwilling

to use floating NAV funds


Investors may turn to less
-
regulated
products


Investors may increase use of bank
deposits


This may lead to constriction of short
-

term credit



Accounting/tax implications

-
A floating NAV generates taxable gains and
losses with each subscription and redemption


Investment policy restrictions

-
Investors restricted from using floating NAV
products will have to find other cash
management solutions


Investment policy impact

-
Using a floating NAV money market fund may
require changes to your investment policy


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Appendix
–

Slide 14 Footnotes

22

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Important information

23

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