With SEC rule changes looming, money funds start shifting their holdings

Funds are starting to shift their holdings in the $6 trillion US money market ahead of a spate of new rules that will likely boost demand for government securities at the expense of riskier assets.

As of mid-April, about five of these funds — including the two largest — had announced plans to convert to government-only holdings or close altogether to avoid Securities and Exchange Commission measures that take effect later this year.

Starting in October, the changes mean it’ll get more expensive to withdraw money from some funds in times of financial stress.

The shift in holdings means increased demand for government-backed instruments ranging from Treasury bills and agency discount notes to repurchase agreements, while reducing demand for commercial paper and certificates of deposit.

That appetite for government debt could drive short-term rates lower, once again making a key Federal Reserve overnight facility more alluring as cash sloshes around the financial system in search of a place to invest.

“When this reshuffling occurs depends on two factors: the timing of planned conversions and how long institutional investors are willing to stay in soon-to-be converted funds,” Barclays Plc strategist Joseph Abate wrote in a note to clients on Tuesday. “So far there are only a few signs of the shift from credit to government assets or fund outflows.”

There’s about $650 billion parked at institutional prime funds, with about $605 billion concentrated in 20 entities, Barclays estimates. And eight so-called internal funds — which are only open to other money market and mutual funds within the complex — account for 60% of balances.

Barclays expects institutional prime fund balances to fall roughly 63% to 75% by October, putting the total amount of assets remaining between $150 billion to $250 billion, and boosting balances in government-only funds by $400 billion to $500 billion.

For government-only funds, demand will be roughly split in similar amounts between Treasuries, agency debt and repo — which is large enough to absorb the anticipated net issuance in second half of the year, according to Abate. As little as $50 billion could flow into the Fed’s reverse repurchase agreement facility, or RRP, though there’s a risk demand climbs much more if public-facing prime funds chose to raise holdings of same-day cash ahead of potential redemptions.

Overall, the impact of rule changes is expected to be more subdued than the last series of reforms in 2016. In the runup to that deadline, about $1 trillion left the institutional prime space for the government-only sector. Such a significant shift in cash caused the spread between three-month commercial paper and overnight index swaps to widen by 32 basis points.

This time, though, institutional prime funds only make up 45% of the prime money-market space — versus more than 70% in 2016. That should “meaningfully reduce” the impact of this round of reforms, according to JPMorgan Chase & Co. strategists led by Teresa Ho.

The buyer base for commercial paper is also more diversified now, with money funds comprising about 24% at the end of 2023, and others like corporates, state and local governments playing a much larger role.

“The scale of the impact as a result of reforms will not be anywhere close to what we saw in 2016,” Ho wrote in a note. “That’s not to say the risk of wider spreads could not transpire in the coming months, but we believe they will be driven by other factors.”