How do money market funds stay triple-A?

Money market funds (MMF) are under pressure; ratings agencies are watching them closely and the universe of underlying AAA rated institutions is getting smaller and smaller. And anyone who thinks a MMF rating isn’t important for local authorities should take a look  at the average treasury investment strategy. You won’t find many (make that any) who are open to investments in money market funds rated lower than AAA.

So in this time of relatively few opportunities and an abundance of risk, how are fund managers maintaining their AAA credit status? We asked three of the major players to talk us through their
strategies.

Stuart Freeman, Fund Manager (Cash and Bonds), CCLA
CCLA’s credit analysis has evolved over the fifty years we have been managing cash funds and has withstood all kinds of nasty global and economic events. We constantly monitor and update the approved lending list for all of our funds and hold an internal formal oversight meeting at least once a month. In
addition, we report to each funds governance board on a quarterly basis. The Public Sector Deposit Fund is unique in having an Advisory Board representing the local authority community, and our reports to them together with daily details about the fund are published on the website.

For all funds, the process covers:-

Credit Ratings: The continuous monitoring of bank ratings that are published by the four major credit rating agencies. A financial institution must firstly meet our minimum requirements, which are generally tougher than those set by the fund’s rating agency.

Sovereign strength and regulatory environment: It is important for a counterparty’s country of domicile to be politically stable and of sufficient credit quality such that it is likely to be in a position to provide support to its banks if necessary. This requires a sensible balance between the size of the domestic banking sector and the country’s financial resources. The sovereign should also have a strong domestic regulatory environment.

Credit default swaps (CDS): We continuously monitor the credit default swaps for counterparties that have a CDS instrument. We use trends compared with average market levels as an early warning signal of trouble ahead.

Issuer yield spreads: We monitor issuer yield spreads on a daily basis for all approved counterparties. This also acts as an early indicator that lenders are re-assessing the level of
counterparty risk.

In-house research: Where there are specific areas of interest or concern, we will undertake further credit analysis. We will not replicate the work of the credit rating agencies but rather to add to it in specific areas. This might involve questioning a bank’s funding model and associated risks, analysing the diversification of revenue sources, or investigating the credit implications of mergers and acquisitions.

News, broker research, company results: Publicly available information is reviewed to see if it might change our view on a counterparty.

Ethical and responsible investment issues (E&RI): We believe that Companies that persistently demonstrate poor E&RI performance are more likely to encounter difficulties. Our in-house E&RI team carry out an annual assessment of our approved counterparties including such areas as:

• Board and board committee composition; including separation of the roles of CEO and chairman, and the existence (and independence) of the audit, nomination, and remuneration committee.
• Compliance to local market corporate governance norms.
• The existence of anti-bribery and corruption policies and procedures.
• The existence of an appropriate code of ethics.

These tools provide the backbone of the credit analysis which we use to ensure that our funds are not only AAA rated, but also in a very strong position even in the most difficult of circumstances.

Emily Mulliner, Vice President, J.P. Morgan Asset Management
In our own money market funds, our investment approach has not changed. We have always been highly conservative, with a focus on capital preservation and liquidity, and this has meant we haven’t had to adjust our investment strategy in our AAA-rated liquidity funds in any significant way. Our internal credit
process remains very robust, and we continually review our approved list and tenors in light of market conditions, making adjustments as changing circumstances warrant. We hold – and always have held – high levels of overnight cash. Diversification is a key consideration for us. We have very low counterparty concentration limits and ensure that our portfolios are diversified in terms of types of securities held, as well as in terms of issuers.

The Eurozone debt crisis serves as an excellent example of the benefits of our conservative approach to credit. Throughout the crisis, we have dynamically managed our buy list and kept tenors short. We have no peripheral exposure in our liquidity funds, and have stayed ahead of the market by removing credits we were less comfortable with very quickly. Ireland was removed from our buy list in February 2009, before being given assistance in November 2010. Portugal was removed in April 2010, before requesting assistance a year later. All Greek names were removed from our approved list on 20 February 2009. We cut exposure to Italy and Spain a long time before the recent market deterioration, and removed them from our buy list entirely in July this year, although we hadn’t purchased any exposure beyond one month for more than a year.

Where money market funds (MMFs) are looking to maintain a stable NAV, it is essential that they are backed by an organisation with the strength, stability and commitment to assure this. Perhaps more than any other asset class, money market funds demand detailed scrutiny of the sponsor’s current and historic financial position. It is also important to ascertain how long a firm has been involved in the sector and what proportion of their overall business and assets it represents.

A striking feature of events in money market funds in late 2008 was the speed at which certain funds in the US (and some in Europe) lost liquidity as credit spreads deteriorated and outflows accelerated. A fund can only assure daily liquidity if it has the scale of assets and the level of investor diversification to honour redemptions of any size at any time. It is therefore essential to assess the size of the specific fund in which assets are to be held (do not just obtain a figure for a firm’s total money market assets), the level of client diversification in the fund, and the fund’s internal policy on shareholder concentration limits. Questions should also be asked about how much of the fund is invested in overnight securities and whether the manager has ever restricted withdrawals from the fund or been required to inject liquidity.

Dennis Gepp, Managing Director and CIO, Prime Rate Capital Management
Developments in the Eurozone and the downgrading of many banks and countries by the rating
agencies have made managing a money market fund increasingly challenging for investment managers. Key to our strategy has always been a continuous focus on the fundamentals that a money market fund needs to provide to its investors. These are security, liquidity and diversification with performance only ever being an aim as long as the first three aims are being met.

We aim to ensure security by:

• Only investing in securities with a maximum maturity of 4 months,
• Having shorter maturity limits for issuers who are not top rated
• Ensuring that we act quickly on possible downgrades of any issuers
• Having a robust credit process which liaises closely with the investment team
• Considering the full range of risks which may impact our investments.

We aim to ensure that we maintain liquidity for our investors by:

• Keeping at least 25% of the fund in overnight liquidity
• Having at least another 5% of the securities maturing within a week
• Only buying securities which we consider and have assessed to be liquid
• Regularly checking the liquidity of securities that we hold by checking bid and offers in
  the market
• Trying to identify issuers who will remain attractive to the rest of the market
• Using our credit process to try to ensure we do not end up holding any issuers which
  may prove difficult
• Not investing in any asset backed securities including asset backed commercial
  paper.

The most challenging area has probably been maintaining a sufficient diversification of issuers in order to meet the requirements of the rating agencies as well as our own investment guidelines. Over the past year many banks and countries have been downgraded, some to a level where we would not be able to hold them due to the rules applied by the rating agencies to AAA money market funds. Despite this we have been able to maintain our diversification by looking hard for alternative issuers. We have particularly focussed on identifying additional strongly rated supra national and sovereign agency issuers. As our approved issuer list has always been relatively short (!) we have been well placed to tackle the challenges of a shrinking universe of high quality issuers.

Our specialist approach to cash management has meant that we are well placed to manage our funds in these difficult times. We have been able to continue to focus on the investment approach of focussing on the key requirements, which we have maintained since our fund launch in 2008.