With corporate debt ruling the headlines, Nick Elfner gives his thoughts on corporate leverage, ratings downgrades, and risks and opportunities in the investment grade corporate space.
On October 14, new SEC rules governing money market funds (MMFs) will take effect. The rules are prompting a tectonic shift in the landscape for institutional prime MMFs by requiring them to transact at a floating net asset value (NAV) and by allowing them to impose liquidity fees and redemption gates.
The new rules have unnerved some MMF investors who were more comfortable with a stable, $1 NAV. Many of those investors have moved from prime MMFs to government money funds, which are not subject to the floating NAV requirements. As a result, both taxable and tax-exempt MMFs have seen significant outflows in recent weeks. For the week ending September 13, prime institutional MMFs reported outflows for the ninth straight week, seeing an exodus of $36.45 billion. Meanwhile, government institutional fund assets rose $48.05 billion, per iMoneyNet.
The new regulation matters for large corporations and banks because taxable prime MMFs invest in a broad swath of short-term securities, including corporate commercial paper (CP). Given investor outflows prompted by the new rules, taxable prime MMFs have reduced their participation in CP over the past several months, reducing liquidity in CP and increasing the funding costs of the short-term debt market as tracked by the London Interbank Offer Rate (Libor) (see chart).
Faced with higher costs of short-term funding and lower liquidity in CP, we unpack how investment-grade banks may fare as the new MMF rules become effective. In our view, there is both good news and bad.
The Good News: Little Impact on U.S. Banks
- Large U.S. banks, finance companies and corporates have reduced their issuance of CP over the past decade (see chart). CP played a central role in the global financial crisis (GFC), and concerns surrounding CP increased sharply as a result. Today, CP utilization is notably low – even zero, in some cases – among U.S. money centers and investment banks.
- Strong demand for high-grade corporate bonds has created fertile ground for banks to term out short-term debt. Demand for high-grade new-issues remains strong (new-issue concessions averaged 7 basis points for the month of August), allowing companies to issue new debt to term out existing short-term debt. For example, on September 6 and 7, corporate issuance totaled $39 billion, including $18 billion from Yankee banks and auto finance companies, per Bank of America Merrill Lynch. These two sectors tend to be large borrowers in short-term funding markets. Year-to-date, the Financial sector– also a prominent user of short-term funding –has issued about 42 percent of U.S. corporate bond new issue volume.
- Prime MMFs have already significantly cut their holdings in CP this year, which could mitigate further upward pressure on Libor caused by prime funds exiting CP. CP holdings in taxable prime funds have dropped to 21.9 percent as of the end of August, versus 25.2 percent at the start of 2016, per ICI.
- Some investors outside of prime funds (such as separately managed accounts) may see rising CP yields as an opportunity. In today’s low-yield environment, U.S. banks’ CP issuance may still find a home with investors looking for more-attractive returns, particularly in those funds with shorter durations that fall just outside Rule 2a-7 guidelines.
The Bad News: Foreign Banks More Challenged
- Some European banks (such as those in Italy) are already facing liquidity challenges. For example, in June, the European Commission gave Italy the go-ahead to supply up to 150 billion euros in government liquidity guarantees for Italian banks struggling with liquidity issues. Banks struggling with liquidity problems may be further strained by higher short-term funding costs.
- Without the benefit of large, low-cost retail deposit bases in the U.S., foreign banks are typically more reliant on wholesale funding than are U.S. banks. U.S. branches of foreign banks (FBO’s) are now mostly prohibited from having retail deposits, so they fund a substantial portion of their dollar assets with wholesale dollar funding such as CP. The lack of liquidity in CP has increased funding costs for some European and Japanese banks that rely more on U.S. dollar CP funding than do their U.S. bank competitors. In August, prime MMFs reduced exposure to Japan by 29 percent, per iMoneyNet.
- At FBOs, without a corresponding increase in yields earned on bank assets, higher dollar funding costs (in Libor) will be expected to reduce net interest spreads and negatively impact the profitability of lending operations. As taxable prime MMFs reduce holdings of CP and CDs, FBOs will likely need to pay higher rates in money markets to nontraditional CP buyers or tap alternative secured and unsecured term U.S. debt markets more frequently.
At Breckinridge, our corporate financial holdings are concentrated in senior debt obligations of large, well-capitalized banks. We believe that this new regulation will have limited impact on our clients’ holdings. We maintain our high-quality bond positioning and continue to perform in-depth, bottom-up research on all our holdings.
 Prime MMF’s held about $835.13 billion in assets as of the end of August, including $49.13 billion of asset-backed commercial paper (down $10.16 billion from July), $114.80 billion of financial-company CP (down $31.73 billion), and $26.01 billion of non-financial CP (down $12.25 billion). Total prime-fund holdings, based on amortized-cost values of all securities. Source: iMoneyNet.
 e.g. General Electric Capital had $5 billion of CP at 12/31/15 compared to $106 billion at 12/31/07, SEC Filings
 On September 16, 2008, the Reserve Primary Fund, a prime MMF with nearly $800 million in exposure to Lehman Brothers, “broke the buck,” or its NAV fell below $1.00 per share. As a result, investors flowed out of higher-yielding MMFs into Treasury-only MMFs and the CP market became severely disrupted.
 e.g. Goldman Sachs had $0 CP outstanding as at 6/30/16, SEC Filings.
 Bank of America Merrill Lynch, as of September 6, 2016. The new issue concession is the amount of additional spread on newly-issued bonds versus the same issuer’s existing bonds.
 See Bloomberg data and LEAG page, as of September 2016.
 Bloomberg, as of June 30, 2016.
 William Goulding and Daniel E. Noelle, Board of Governors of the Federal Reserve System, International Finance Discussion Papers, Number 1064. November 2012. Kevin Buehler, Peter Noteboom and Dan Williams, McKinsey Working Paper on Risk, Number 48, “Between deluge and drought: The future of US bank liquidity and funding,” July 2013. Jeremy C. Stein, Board of Governors of the Federal Reserve System, remarks given at the Global Research Forum, International Finance and Macroeconomics, sponsored by the European Central Bank, Frankfurt am Main, Germany, December 17, 2012.
 Net interest spread = Interest yield on earnings assets minus interest rates paid on borrowed funds. Source: Bloomberg.
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