The European Central Bank's historic move to cut its deposit rate to -0.1% on June 5 will negatively impact the Euro money markets, but will it lead to negative yields? It's not likely, analysts say, but the possibility does exist. "The overnight rate that MMFs can invest in is driven by the EONIA curve and if EONIA edges lower as a result of the cut in ECB's deposit rate, the risk of MMF net yields falling near zero or lower is likely to increase," writes Vikram Rai, analyst at Citi Research in a paper he authored called "ECB and ECP: How will Euro MMFs cope with negative rates?."
Writes Rai, "The long suffering global money fund industry has become somewhat accustomed to dealing with onerous regulatory requirements and years of near zero interest rates which have led to sustained lower profitability. As a result, money funds have become more nimble and cost effective in their bid to survive. But, and needless to say, negative short term rates will have a less than beneficial impact on the already diminished prospects of the Euro money fund industry. In anticipation of the dreaded rate move into negative territory, some CNAV Euro MMFs have modified their investment and operational structures in order to deal with negative returns. For instance, if on a day, the assets of the money fund minus fees and expenses produce a negative return, the fund would take steps to ensure that the NAV per share remains stable at E1 per share. In order to achieve this, the number of shares held by each investor will be reduced pro rata to reflect the negative return of the money fund for that day. This mechanism will be implemented via a share redemption where the proceeds of the redemption will not be paid to the investors and will be retained by the money fund to meet the negative return."
Also, explains Rai, "Rating agencies have stated that negative net yield posts by MMFs, by itself, will not be a catalyst for downgrades as ratings reflect credit, liquidity and market risk profiles." (Note: Fitch Ratings issued a press release on June 6 stating, "Should Euro MMFs post negative yields resulting from short-term market rate moves, this would not be a negative for MMF ratings by itself, including 'AAAmmf'. MMF yields have to reflect prevailing safety and liquidity costs, commensurate with alternative high quality short-term instruments. Fitch's MMF ratings are a ranking of funds on the basis of their liquidity, market and credit risk profiles."
However, while downgrade risk isn't imminent, "money fund investors are unlikely to adapt easily to the continued erosion in the value of their investments and would be inclined to pull funds and look for investment alternatives, which would at least offer positive yields," says Rai. "The ECB cut its deposit rate to zero in the summer of 2012 and in the aftermath of this action, many of the world's largest money fund providers either closed their Euro money funds to new investments or restricted deposits while smaller funds were forced to shut down. We expect similar consequences this time also which will likely drive further consolidation of Euro zone money fund industry," he states.
The current average 7-day yield according to Crane's Euro Money Fund Index, as of June 16, is 0.08%, down 0.02% over the last 7 days and down 4 basis points since June 5. So, while low, there isn't any imminent threat of yields going negative, and it's still higher than it is in the U.S, where the average 7-day yield, according to our Crane Money Fund Index, is 0.01% as of June 16.
The potential for negative yields has been on money fund managers' radar for several years now, but we have yet to see anything more than a brief flash negative in isolated markets. In our November 2012 issue of Money Fund Intelligence, we wrote about a new "flex" distributing share class J.P. Morgan launched for two of its euro money market funds, the Euro Liquidity Fund and the Euro Government Liquidity Fund. The flex share class is designed specifically to manage low or negative yields and was created in response to the ECB's decision to lower its deposit rate to 0.00% on July 5, 2012. We wrote, "The "Flex" shares would allow the funds to maintain a stable NAV in a potential negative yield environment by automatically selling shares to cover expenses and debits from any yields below zero. The "Flex" shares would allow the funds to maintain a stable NAV in a potential negative yield environment by automatically selling shares to cover expenses and debits from any yields below zero." (Note: JPM has not used the "flex" feature to date.)
We added, quoting Moody's, "Faced with historically low yields, many MMF managers have reduced or waived their management fees in order for their MMFs to deliver a positive net yield. The prospect of a prolonged period of low to negative yields on high‐quality, short term investments adds to the challenges already faced by the MMF industry and is creating a number of unprecedented issues for MMF managers. In the immediate term, the greatest impact will be on Euro-denominated government funds, given their limited investment options; however, in due course, zero to negative‐yielding securities will exert pressure on prime funds in Europe, as well as government and prime funds in the US."
There was also some concern in December 2008, and again briefly in December 2012, of negative yields in the U.S. causing money fund's assets to fall below $1 share. The fear was that it would lead to investment losses on money market funds, which in turn would lead to a run on money fund investments. However, such a scenario is highly unlikely today as money fund managers have been repositioning their portfolios in anticipation of the Euro rate cuts to minimize risk (and unlikely in the U.S. because of yields above zero and the Fed's new reverse repo "floor"). `According to Fitch, the risk of MMF yields turning negative is lower now than it was 18 months ago when Eurozone liquidity was under stress. As of June 16, net assets in euro money funds is $78.3 billion, according to the Crane Euro Money Fund Index, up $52 million over the last 7 days.
