As the US economy continues to show signs of improving health and interest rates generally trend upwards, it is an appropriate time to take inventory of an area deeply embedded within the fiscal and regulatory crosswinds of the times: Money Markets. Regulators’ efforts to protect Money Market investors via October 2016 reforms to Rule 2a-7 and other legislation have led to a significant exodus from prime to more secure government funds. This supply-demand mismatch is a powerful signal that the reforms are upending institutional cash management and changing the dynamics of historically under the radar instruments like M&A Escrow.
For more expert insight, we caught up with Ed Dombrowski, Vice President, Money Markets; Jeff Skoglund, Director of Credit Research; and Eric Winograd, Senior Vice President-US Economist at AllianceBernstein (AB) to discuss the state of the Money Markets during these complex times. Continue reading below:
MW: Ed, could you describe your role on the Money Markets desk and outline some of the biggest challenges you face on a day-to-day basis?
ED: As a Government Money Market Portfolio manager, the biggest challenge I face has been finding securities that add value for investors in a constantly shifting environment.
To illustrate, I’ll provide an example based on current marketing conditions. While the March rate hike was a welcome relief, the six to eight months prior to that saw the market trying to adjust to the huge shift in assets from prime to government funds. This time frame was precipitated by the implementation of new regulations meant to curb risk in the money-market industry. The subsequent lack of investment in prime, the higher-yielding portion of money markets, has created a challenge when seeking returns since most of the viable funds are comprised of low interest bearing government related securities.
Another interesting layer of my role relates to the expediency of this supply demand mismatch. With less cash returning to prime funds, a potential inventory issue could augment the imbalance. This is further compounded by political uncertainty revolving around the U.S. debt ceiling.
Overall, these are the factors that demand my attention on a day to day basis.
MW: The SEC regulatory reforms of October 2016 require money market accounts to have enhanced liquidity requirements and be able to pass more stringent stress tests. How have investors & financial institutions been impacted since then and what are your thoughts on the reforms?
ED: While the markets did have ample time to prepare, we have witnessed the aforementioned exodus from prime to government funds, which was a significant shift of assets.
Regarding the reforms, I believe in some ways they were far reaching and potentially contrarian to the very principals upon which money market accounts were built. For example, one stipulation is a “floating rate NAV” meaning that one dollar invested no longer guarantees one dollar out. This poses a potential challenge to the preservation of capital required by some institutional guidelines. The allowance for fund redemption gates, which prohibit withdrawals at certain times, also demands consideration as it pertains to the liquidity of funds. In conjunction with gates, investors may have to also contend with new fees.
MW: So what types of investment vehicles are being impacted by the reforms and how does this correlate to M&A?
ED: Options for investment vehicles that preserve capital and provide liquidity have dwindled due to the reforms. Therefore, investors will have to pay closer attention to where they invest institutional cash. An example of this is M&A Escrow.
With M&A, the parties often want to ensure principal is guaranteed and money is accessible as the transaction goes through closing, for claims or otherwise. Traditional prime funds may no longer be a viable option for something like M&A escrow.
Also, while yield for certain vehicles has taken a back seat, institutional investors should now give more consideration to interest earned on corporate cash since a lack of yield will become more noticeable with more rate hikes.
MW: Thank you Ed. Continuing on the M&A track, Jeff, what is your forecast for 2017 private target M&A? Do you think it will grow or stagnate?
JS: At this point, it’s hard to predict. The overall backdrop--low interest rates, stable equity markets, and the desirability of strategic growth when organic growth is limited across many industries--is conducive to continued M&A activity even though we may have seen the peak for the current cycle in 2015. On the positive side, reduced regulations and fiscal stimulus could drive expansionary agendas at corporates, leading to more M&A activity. However, cross-border transactions and those targeting U.S. job-related cost synergies will risk potential consequences from this political administration.
Another constraint is that the cost of debt financing is going up in both an absolute and relative, to equity financing, manner. This is a result of rising rates and a reduction in the tax shield. Consensus view is that pre-existing debt will be grandfathered if the interest deduction goes away.
We are, however, hearing from bankers that the M&A pipeline is reasonably strong with companies pursuing deals ahead of higher rates and tax law changes. As a general note, strong equity market valuations and low volatility (VIX) usually translates to higher M&A activity. From the IPO perspective, elevated valuations, particularly in tech, make for a favorable outlook.
MW: Eric, since interest rates are a catalyst for shifts in the market, what is your rate forecast for 2017?
EW: We expect the Fed to continue the gradual increase in rates, most likely with two more hikes in June and September. However, we expect the FOMC to skip the December meeting and instead begin to slow the rate of reinvestment of maturing securities from its portfolio in order to shrink its balance sheet, assuming that the economy continues to cooperate. We think they will take great pains to do this in a way that is not disruptive for the market. So, expect 10-year Treasuries to sell off only modestly from here. Our year-end forecast is 2.75%.
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