Fitch on Rate Hikes, WAMs and Shadow NAVs; More Revised SEC FAQs

In preparation for likely interest rate hikes and pending money market fund reforms, money fund managers are reviewing their portfolios with an eye on average maturities and “topping up” shadow NAVs, according to a new report by Fitch Ratings, entitled, “Fund Managers Brace for Rate Hikes and Reform; Shadow NAVs Come into Focus.” The piece says, “Anticipated increases in U.S. interest rates are pushing money funds across the board to shorten portfolio maturities to take advantage of higher rates. Furthermore, underlying data indicate that prime funds are adjusting their weighted average maturities (WAMs) more aggressively than government funds due to additional reform-related pressures.” In other news, we also revisit the updated “Frequently Asked Questions on Money Market Reform” version that the Securities & Exchange Commission, released last week.

The Fitch report explains, “Many money funds have migrated to shorter WAMs since the beginning of the year and, in doing so, have reduced their duration risk. Between Jan. 15 and July 27, the number of prime and government funds with WAMs between 41 and 60 days decreased to 112 from 192, while the number with WAMs between one and 40 days increased by 81 funds. Prime funds have been more proactive than government funds in reducing portfolio average maturities and building liquidity, as these funds have to contend with potential reform-related redemptions, in addition to rising rates. The number of prime funds with WAMs longer than 40 days declined to 48 from 102, while government funds have been slower to reduce maturities.”

It continues, “The looming conversion to floating net asset values (NAVs) for institutional prime and municipal funds is leading fund managers to focus on funds’ current shadow NAVs, which reflect market pricing. As money funds currently transact at a stable $1 NAV, a key implication is that funds with a shadow NAV of less than $1 will immediately crystalize losses for investors upon conversion to a floating NAV. To avoid losses for investors, some fund managers have taken steps to bring shadow NAVs up to $1 through capital injections, and others may follow in the coming months.”

Fitch writes, “For example, Crane Data reported that Northern Trust took a $45.8 million charge in the second quarter over a capital injection used to top up the shadow NAVs of four funds, citing legacy losses from the financial crisis as the cause of the shortfall. Northern Trust did not specify the affected funds, but Fitch’s review of data from Crane shows that the shadow NAV of the Northern Trust Money Market Fund increased from $0.9989 on July 9, 2015 to $1 the next day. If the increase in the fund’s shadow NAV was a result of a capital infusion, it would have cost approximately $8 million. Although the fund is considered a retail fund and, therefore, will not convert to a floating NAV like institutional funds, Northern Trust will still have to post the fund’s shadow NAV on its website, which may have been one of the reasons for the top up.”

On the issue of shortening WAMs, JP Morgan Securities’ Alex Roever wrote in the weekly “Short-term Market Outlook and Strategy,” “MMFs continued to manage short portfolios, further reducing their maturities to prepare for a potential Fed move. Year-to-date, both prime and government MMFs have shortened WAMs by 9 days. In fact, at 33 days, prime fund WAMs are now at their lowest levels we have on record. With a tightening cycle on the horizon, we look for WAMs to fall even further going into September.”

In other news, we continue our coverage of the SEC’s updated FAQs. (We mentioned them in our August 7 News and our August 10 Link of the Day, “SEC Updates MMF Reform FAQs.” In the SEC’s latest update, some new FAQs were added, including FAQ 22, “May a retail money market fund continue to rely on the retail exception where some of its shares have been transferred to state custody under applicable escheatment or unclaimed property laws?

The SEC replies, “State laws may require a retail money market fund or a financial intermediary to transfer escheated or unclaimed shares to a state’s treasurer or other administrator. This may be accomplished by transferring the shares into a securities account in the state administrator’s name or otherwise turning over the shares to the state. The state administrator maintains custody over such shares until they are reclaimed by the missing owner. Accordingly, so long as the missing owner has the right to reclaim escheated or unclaimed shares, the staff would not object if a retail money market fund or a financial intermediary continues to rely on the retail exception.”

FAQ 31 is also new. It asks, “Some money market funds have charters providing that the fund may suspend redemptions only in certain specified circumstances, such as during an emergency. If a money market fund imposes a redemption gate, would it be doing so as the result of an “emergency”? The SEC responds, “Yes. Under rule 2a-7(c)(2)(i), a money market fund is allowed to impose a redemption gate only in extraordinary circumstances, i.e. if the fund’s weekly liquid assets fall below 30% and the fund’s board of directors determines that imposing a gate is in the best interest of the fund. In the staff’s view, such extraordinary circumstances would in effect likely create an emergency for the fund. Accordingly, the staff believes that a suspension of redemptions by a money market fund, as permitted by rule 2a¬7(c)(2)(i), would be because of such an emergency.”

Also, FAQ 13 is on Form PF, which relates to Private Funds. The FAQ asks, “The compliance date for the amendments to Form PF is April 14, 2016, which falls during the 15-day filing period for the first quarter ending March 31, 2016. Should a large liquidity fund provide the new portfolio holdings information required under the Form PF amendments in their first quarter 2016 filing? The answer is: No. If filers were to include the new portfolio holding data as of April 14, 2016, it could create disparities, because filers who file before April 14 during the 15-day filing period would not be required to include the new data, but those who filed afterwards, on the deadline date of April 14, would include it. Therefore, staff does not believe that large liquidity funds should include the new portfolio holdings information required under the Form PF amendments in their first quarter 2016 filing. The first Form PF filing with such holdings data should be the second quarter filing, covering the period between April 1, 2016 and June 30, 2016. Having all filers begin to submit portfolio holdings information at the same time will help maintain the integrity and comparability of data filed on Form PF and reduce potential systems issues.”

Finally, there was also a new language added to the former FAQ 42, now 45, which asks: “If a state, municipal or foreign government or its agencies or instrumentalities owns (directly, through legislative act or other means) more than 50 percent of an entity’s voting securities, is a money market fund required to treat such entity and the state, municipal or foreign government or its agencies or instrumentalities that owns more than 50 percent of that entity’s voting securities as a single issuer for purposes of the five percent issuer diversification provision?”

The following passage was added to the answer: “A money market fund also must treat two or more issuers as one single issuer if one issuer is controlled by, or under common control with the other issuer. In the staff’s view, a state, municipal or foreign government or one of its agencies or instrumentalities that does not issue voting securities, as is typically the case, is not considered controlled by or under common control with another entity. If a state, municipal or foreign government or one of its agencies or instrumentalities does issue voting securities, however, the above diversification requirements would apply to such issuer.”

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