Good morning. The last time I sat down with Rob at FT headquarters in New York, we talked about recent fashion trends. (Some readers will recall that he regularly moonlights as our resident menswear correspondent.)
Shortly after this conversation, I was asked to substitute for Mr Armstrong on Unhedged.
Naturally, I’m trying to focus on the positives — my newsletter debut! And not the negatives — that Rob may be quietly suggesting I stick to my markets day job, and put “style guru” in the rear-view mirror.
In any case, hello! This is Harriet Clarfelt and I’m delighted to be writing for you today. If you have any feedback (or indeed sartorial tips), please feel free to contact me at harriet.clarfelt@ft.com.
I refer all complaints to Rob, who will be back with you next week when he returns from the FT’s Business of Luxury (of course) summit.
Money market fund closures
A handful of cash managers including Vanguard and Capital Group are planning to shut some of their US money market funds, or convert them to different structures, instead of paying for upgrades to comply with new rules due later this year.
So, what happens to the short-dated debt held by these funds? Will it be scooped up by other buyers? Is there enough demand elsewhere?
The short answer appears to be: yes, probably. But it’s a situation we’ll be monitoring closely in the next few months.
Some context first. The Securities and Exchange Commission will implement regulations in early October that target prime institutional money market funds. Unlike government funds, these can hold short-dated company and bank debt.
The new rules mean that a liquidity fee will be imposed on departures whenever net redemptions exceed 5 per cent of a fund’s total net assets in a single day.
The idea, in essence, is that such charges will help protect investors by preventing large-scale exits from prime institutional vehicles like those seen at the start of the Covid crisis in 2020, when some managers had to sell assets at discounts to handle outflows.
But as we wrote last month, a few cash managers have said they’ll either close funds or convert them to another type of vehicle before the SEC rules come into play.
Vanguard and Capital Group are two such converters, both switching multibillion-dollar internal funds used by their portfolio managers for cash management from prime to government assets.
Based on overall announced closures or conversions so far, US institutional prime money market fund assets are on course to shrink by more than a third this year, or roughly $220bn out of a total market size of $625bn, according to Crane Data.
So, what are the implications for some of the assets these funds own — namely US commercial paper and US banks’ certificates of deposit?
First off, the buyer base for these instruments has diversified significantly since the last set of US money market reforms in 2016, which also prompted a wave of conversions.
One big change is that prime retail funds — the domain of private investors — have grown considerably, and are now larger overall than their institutional counterparts. Crucially, prime retail money market funds will not be affected by October’s rules. That should help to plug any potential demand gaps.
Commercial paper buyers are also broadly “much more diversified now, with MMFs comprising less than 25 per cent of the market”, Teresa Ho, JPMorgan’s head of US short duration strategy, wrote earlier this month. “Even if prime fund exposure to the CP market were to decrease slightly, the remaining buyer base could step in to absorb lost capacity.”
Robert Crowe, Citi’s head of money markets origination, predicts that borrowing premiums (aka spreads) for commercial paper may widen a little in the next few months.
But this could entice other buyers into the space, attracted by cheaper pricing to move opportunistically.
Additionally, since the Federal Reserve started raising interest rates in early 2022, available yields on various short-dated instruments have soared.
With that in mind, “we’re pretty confident that the commercial paper market will be robust for some time”, says Citi’s Adam Lollos, head of short-term credit trading and origination. “Especially as we have higher interest rates that seem like they’re going to hang around for some time.”
I’m inclined to agree that a few fund closures shouldn’t spark major disruption for a pool of assets whose buyer-base has broadened considerably in recent years — and while demand for short-dated paper remains strong.
Particularly compared with the last reforms eight years ago, when money market funds had to switch from a fixed to floating net asset value. That helped to send roughly $1tn flowing out of prime institutional vehicles at the time, according to JPMorgan, pushing commercial paper spreads considerably wider.
Shelly Antoniewicz, deputy chief economist at the Investment Company Institute, points out that funds that have announced liquidations or conversions have already started shedding commercial paper. But she adds that available data suggests “companies don’t currently seem to be having problems placing commercial paper”. Somewhat reassuring.
Still: liquidity in short-dated instruments is essential to the smooth-running of overall market infrastructure. So, we’ll be keeping a close eye on this space — and we welcome your thoughts.
To BBB or not to BB?
And thus we move on to longer-dated corporate debt.
US and European credit spreads continue to hover around their lowest levels in well over two years.
Those metrics — signalling the premium that companies pay to issue bonds over government yields — are closely watched, in part because they show how much default risk investors are pricing into their portfolios.
Earlier this month, the average US high-yield bond spread came tantalisingly close to its narrowest level since the start of the global financial crisis in 2007, according to Ice BofA data.
Foolishly, I became rather excited about this, and flagged it to my colleagues. That’s because I forgot one of the golden rules of markets journalism: if you predict that something will happen, it probably won’t. At least not for a while.
Still, the story is more interesting when you look under the bonnet. The gap has shrunk between spreads on triple-B rated debt — the bottom rung of investment-grade credit quality — and double-B bonds, the highest rung of high-yield or “junk”.
For US bonds, the difference between these spreads is just 0.69 percentage points — around its lowest since early 2020, and roughly half of what it was last May, according to Ice BofA data. The narrative appears more extreme in Europe, where the gap sits at 0.79 percentage points — around its narrowest since 2007.
Much of this has been helped by yield-hungry investors piling into corporate debt, while available returns remain much higher than they were before the Fed and peers started increasing rates. Investors have also scrutinised economic data for evidence that they will indeed see rate cuts from central banks later this year.
Technical dynamics are playing a key role, says Mike Scott at Man Group. Aided partly by rating upgrades, the double-B asset class has shrunk for both US and European bonds.
Together with strong inflows, this has kept a lid on spreads.
Christian Hantel, portfolio manager at Vontobel, believes that “this can really go on for some time — as long as we see solid inflows into the asset class”.
But that’s the sticking point. Sentiment can change — and there are arguably a number of potential triggers in the months ahead, from macro data to any election-related volatility.
“The rally could immediately stop if we see outflows, obviously,” Hantel adds.
Still, it’s likely to be the lowest-quality triple-C bonds that feel the heat the most if risks begin to rear their head again. This segment is also much more exposed to idiosyncratic corporate problems — not a place to venture without guts and super sharp credit analysis.
One good read
Things are changing in corporate credit.
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