Since the beginning of the month, both the stock and bond markets have experienced unprecedented levels of volatility. In response to the uncertainty over the novel coronavirus (COVID-19) and the shocks from the Russia-Saudi Arabia oil price war, the Dow Jones Industrial Average has sold off almost 32% from its high on February 12, reaching a low of 20,188 on March 16.
At the same time, both corporate and government bond markets have experienced a high degree of pricing volatility and, at times, strains on smooth operation, leading investors to shun those asset classes.
As investors reduce their holdings of risk assets and seek a perceived safe haven, the money market fund industry has seen historically high flows into government funds. At the same time, there is some rotation out of prime funds and into government funds. This, in turn, has introduced more volatility into the shorter end of the yield curve.
The U.S. Federal Reserve (Fed) has reacted rationally to the unprecedented economic slowdown that is facing the nation and world for at least the next several months by cutting interest rates to zero again, expanding its repo offerings, beginning another round of quantitative easing, and announcing some form of backstop for the commercial paper market.
Government money market fund snapshot
In the government money markets, the Fed has set the reverse repo and interest on excess reserves rates at 0.00% and 0.10%, respectively. Eventually, rates for all of the government products, including repos, Treasury bills (T-bills), and agency discount notes, should move down nearer those levels.
The strains in all financial markets have made an impression even on exceptionally deep markets like those for repos and T-bills, widening bid/offer spreads. Despite that, trading in those markets has continued to be orderly. The best measure of where the market is actually trading is the level at which the weekly T-bill actions have stopped. On Thursday, March 12, before the Fed’s last 1% interest rate cut but largely in anticipation of it, the 4-week and 8-week T-bill auctions yielded 0.395% and 0.290%, respectively. On Monday, March 16, with the federal funds rate officially at zero, the 3-month and 6-month auctions yielded 0.29% and 0.30%, respectively.
Modest repo market strains surfaced as rates moved higher relative to the Fed’s target range. On March 16, tri-party repos traded at approximately 0.25% before moving to about 0.50% the next day. This dislocation is far from as extreme as it was last September, when rates temporarily moved 3% higher. The Fed has offered up to $1 trillion per day each in term and overnight repo operations to keep the financial system flooded with liquidity.
In light of the Fed’s liquidity measures, repurchase agreements in the short-term space are abundant. This gives money market funds with the ability to invest in repos the scale to accommodate investors looking to place large balances.
Our government money market fund strategy
Our overall strategy of maintaining a high degree of liquidity balanced by a longer-term portfolio diversified among agency securities, Treasury securities, and floating-rate notes remains unchanged.
Our funds have modestly extended their weighted average maturities by opportunistically buying fixed-rate securities while continuing to emphasize liquidity. At the same time, though, we are mindful of market conditions and are able to rapidly adjust liquidity to accommodate shareholder needs.
Prime money market fund snapshot
To say the Fed takes the smooth operation of the money markets seriously would be an understatement. To dampen volatility, ensure liquidity, and support the smooth operations of the market, the Fed has offered over $2.2 trillion to the market in overnight and term open market operations and direct security purchases, with $859 billion outstanding as of March 17. It stands ready to offer overnight operations of $1 trillion.
Although the Fed’s bazooka corrected some conditions in the funding and short-term Treasury markets, conditions in the short-term commercial paper markets deteriorated over the month. For example, during the first week of March, BA Securities estimated approximately 76% of trading volume was in the one-week and shorter area, with approximately 91% of issues trading with maturities of one month or less.
As market participants of all sorts began putting a premium on extremely liquid assets, trading across the curve became more sticky.
On March 17, in response to the constraints on short-term markets, the Fed dusted off its 2008-era playbook and reintroduced the Commercial Paper Funding Facility. This tool is designed to permit the Fed to fund a vehicle that will purchase, under certain circumstances, commercial paper from market participants. The intent of the program is to facilitate liquidity in, smooth functioning of, and provide access to the short-term markets for investors and issuers alike.
Our prime money market fund strategy
Our prime strategy is focused on meeting the liquidity needs of our clients. In response to markets, we have shortened the liquidity profile of our weekly liquid assets to emphasize more immediately available cash. Until market volatility abates, we do not view this as an opportunity to add securities to the portfolios and instead remain focused on liquidity.
Despite constrained markets, we do not see a deterioration in issuers’ credit quality. Banks are in much better shape now than in the 2008 crisis, as are corporate balance sheets. The overall credit quality in money market funds remains solid.
We view the volatility in short-term funding markets to be a temporary phenomenon and not a “new normal” that will be resolved as participants gain more clarity about the uncertainties surrounding the impact of the coronavirus.
Short duration snapshot
The challenging liquidity environment in commercial paper has extended to the front-end corporate bond and asset-backed securities sectors. Investor selling of corporate exchange-traded funds and municipal bond funds has exaggerated pricing movements, which have become detached from underlying fundamentals. In many instances, Wall Street dealers are only able to facilitate transactions by finding willing parties prior to trading.
Through the close on March 16, the option-adjusted yield spread on the ICE BofAML 1–3 Year U.S. Corporate Index was higher by 157 basis points to 226.
Our short duration strategy
Prior to the market shock, portfolios had been increasing allocations in higher-rated sectors such as asset-backed securities, mortgage-backed securities, and taxable municipals at the expense of the corporate sector. We are being proactive in discussing liquidity needs with clients and making available any cash that might be needed either through maturities or outright selling.
For clients who do not have liquidity needs, we are using the market dislocation to purchase securities that are favored by the Wells Fargo Asset Management Global Credit Research team and that have improving credit profiles. Due to market dynamics, there are many instances where issuance from fundamentally sound companies can be purchased in two- and three-year tenors at higher yield spreads than longer tenors. The team believes this is a good opportunity to increase corporate sector allocations.
Separate accounts are positioned short relative to benchmark durations given the extraordinarily low interest rates offered across the yield curve.
The municipal money market space experienced elevated selling—primarily by bond funds that were hit with sizable outflows for the first time in over a year. Municipal money market fund assets have remained stable.
The Securities Industry and Financial Markets Association Municipal Swap Index, reset at 1.28%, up from 1.25% the prior week. This compared with the 1-week London Interbank Offered Rate at 0.64%. It is expected that the index will reset significantly higher on this week.
Overall, rates continue to rise at a rapid pace. While overnight rates reset in the 2.50%–4.00% range on March 17, rates in the one-year area rose from 0.44% last week to 1.21% on March 17. Secondary trading of short-term notes continues to remain elevated and price action is volatile.
Our municipal money market fund strategy
We continue to focus on maximizing liquidity by investing primarily in variable-rate demand notes and tender option bonds with daily or weekly puts and by seeking opportunities to add high-grade fixed-rate debt while still maintaining lower weighted average maturities than our peers.
Our municipal money market funds remain highly liquid with daily liquidity in the 15%–20% range and weekly liquidity at 90%.
We continue to expect tax-exempt floating-rate securities to remain relatively cheap due to tax-time technicals, but the dramatic rate cuts by the Fed will ultimately result in lower yields in the municipal space.
Jeffrey L. Weaver, CFA, is a senior portfolio manager and head of the Municipal Fixed Income and Short Duration Fixed Income teams and head of Money Market Funds at Wells Fargo Asset Management (WFAM). Laurie R. White is senior portfolio manager for the WFAM Short Duration Fixed Income team, where she is responsible for managing all money market funds. Henri Proutt is a portfolio manager for the Short Duration Fixed Income team at WFAM.
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For floating NAV money market funds: You could lose money by investing in the fund. Because the share price of the fund will fluctuate, when you sell your shares they may be worth more or less than what you originally paid for them. The fund may impose a fee upon sale of your shares or may temporarily suspend your ability to sell shares if the fund’s liquidity falls below required minimums because of market conditions or other factors. An investment in the fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The fund’s sponsor has no legal obligation to provide financial support to the fund, and you should not expect that the sponsor will provide financial support to the fund at any time.
For retail money market funds: You could lose money by investing in the fund. Although the fund seeks to preserve the value of your investment at $1.00 per share, it cannot guarantee it will do so. The fund may impose a fee upon sale of your shares or may temporarily suspend your ability to sell shares if the fund’s liquidity falls below required minimums because of market conditions or other factors. An investment in the fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The fund’s sponsor has no legal obligation to provide financial support to the fund, and you should not expect that the sponsor will provide financial support to the fund at any time.
For government money market funds: You could lose money by investing in the fund. Although the fund seeks to preserve the value of your investment at $1.00 per share, it cannot guarantee it will do so. An investment in the fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The fund’s sponsor has no legal obligation to provide financial support to the fund, and you should not expect that the sponsor will provide financial support to the fund at any time. For the municipal money market funds, a portion of the fund’s income may be subject to federal, state, and/or local income taxes or the alternative minimum tax. Any capital gains distributions may be taxable. For the government money market funds, the U.S. government guarantee applies to certain underlying securities and not to shares of the fund.
Carefully consider a fund’s investment objectives, risks, charges, and expenses before investing. For a current prospectus and, if available, a summary prospectus, containing this and other information, visit wfam.com. Read it carefully before investing.