Portfolio Manager Commentary
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Overview, strategy, and outlook: as of April 30, 2013
Contributing authorsDavid D. Sylvester, Head of Money Funds, Senior Fund Manager
612-667-5107 | david.d.sylvester@wellscap.com
Laurie R. White, Managing Director and Senior Fund Manager, Taxable Money Funds
612-667-4275 | laurie.r.white@wellscap.com
Michael C. Bird, Senior Fund Manager, Taxable Money Funds
612-667-6529 | michael.c.bird@wellscap.com
Madeleine M. Gish, Senior Fund Manager, Taxable Money Funds
415-396-2668 | madeleine.gish@wellscap.com
John R. Kelly, Fund Manager, Taxable Money Funds
612-667-2045 | kellyjr@wellscap.com
James C. Randazzo, Senior Fund Manager, Municipal Money Markets
704-374-3086 | jrandazzo@wellscap.com
Daniel J. Tronstad, Senior Fund Manager, Taxable Money Funds
612-667-7647 | daniel.j.tronstad@wellscap.com
Michael W. Shinners, Senior Investment Research Analyst
612-667-5523 | michael.w.shinners@wellscap.com
Money market overview
The European Union (E.U.) is taking steps toward adopting a financial transaction tax (FTT) that could significantly affect U.S. dollar-denominated money markets. Broadly defined to cover all markets, instruments, and actors, the FTT is slated to become effective January 1, 2014, and has several objectives, as detailed by the European Commission. The FTT is intended to reduce the number of different approaches to national taxation; ensure the financial sector makes a fair and substantial contribution to public revenues; and support regulatory measures that encourage the financial sector to engage in more responsible activities—those the European Commission views as geared toward supporting the real economy.
Similar efforts failed at the G-20 and E.U. levels, but now 11 member states—representing two-thirds of E.U. gross domestic product (GDP)—have indicated that they would approve the common FTT under a process called enhanced cooperation, which requires the approval of nine member states in order to move ahead. The 11 countries that have approved the FTT are Austria, Belgium, Estonia, France, Germany, Greece, Italy, Portugal, Slovakia, Slovenia, and Spain. The proposal is currently being examined by a European parliament committee, after which it will be discussed by the 27 member states. Only the 11 states above will have a vote, however. If they approve the effort, it is scheduled to be passed by the national parliaments by the end of September and go into effect at the beginning of 2014.
The minimum tax applied to various transactions will be initially set at 0.10% of the amount of the transaction for shares and bonds, units of collective investment funds, money market instruments, repurchase agreements (repos), and securities lending arrangements and 0.01% for derivative products. Transactions involving the primary markets, public bodies managing public debt, European Central Bank/European Financial Stability Facility/European Stability Mechanism transactions, spot foreign exchange, central clearing collateral, and many day-to-day household transactions will be excluded from the tax. Importantly, the tax is collected from both counterparties for the same transaction, except for repos and securities lending arrangements where the operations are viewed as a single credit operation. It is important to note that the 10-basis point (bp; 100 bps equals 1.00%) tax is not an annualized rate but rather a percentage of the value of each transaction, so in the case of a repo, for example, it would apply each time the repo was rolled over. Clearly, this would make short-term transactions like overnight repos economically untenable.
Critically, as a means to prevent tax avoidance, the FTT has adopted a broad definition of the parties that would be subject to the tax. The residence principle ensures that any party to a transaction established in the 11 member states would be subject to the FTT, if applicable, regardless of where the transaction takes place in the world. Under the issuance principle, applicable financial instruments issued in one of the 11 member states will be taxed irrespective of the location where the transaction took place. So, if a U.S. broker/dealer sells a German security to a U.S. investor, each would pay Germany 10 bps. The collection of the tax is an important mechanic that needs to be vetted but broadly affects both counterparties to a transaction on a joint basis; if one party to the trade fails to pay the tax, the other party is liable for it.
There are several other mechanical issues to be worked out prior to implementation, and several countries have voiced objections, including Sweden, the U.K., and the U.S. In fact, the U.K. has initiated a lawsuit to block the FTT, claiming proposals adopted by the enhanced cooperation procedure may distort competition; Luxembourg has voiced its support of the U.K. position.
As written, the FTT has significant implications for U.S. investors, including money market funds. While it does not appear that the tax would apply to new issuance, it would apply to secondary market transactions and repos. Clearly, these instruments do not yield enough at this point to offset the amount of a tax. Depending on the outcome of legal interpretations, transactions between U.S. money market funds and the U.S. branches of banks headquartered in the 11 member states may be subject to the tax. Money market funds could reasonably be expected to pull back from funding in that case, leading to tighter credit conditions in those countries and exacerbating the supply constraints that money market funds already face. Further, to the extent that the tax raises funding costs for these banks, it merits attention on the credit front.
The FTT is not a done deal. Member states and working groups may propose changes that would lessen the impact on short-term instruments, and the U.K. legal challenge is a serious threat. We do not dismiss this effort simply because it seems radical or outlandish; those do not seem to be effective criteria for assessing the likelihood of government action. For example, the idea of a ban on shorting sovereign credit default swaps (CDS) in Europe was discounted by the markets, but it was adopted nonetheless. We would caution that since the 11 member states have self-selected themselves for the FTT, the political will to implement it in those jurisdictions would seem to be high. While U.S. money market funds and their shareholders are appropriately focused on the next regulatory challenges coming from the Securities and Exchange Commission and the Financial Stability Oversight Council, this effort also has the potential to change the market landscape and thus merits our attention.
Rates for sample investment instruments
Current month-end % (April 2013)
| Sector | 1 day | 1 week | 1 month | 3 month | 6 month | 12 month |
|---|---|---|---|---|---|---|
| U.S. Treasury repurchase agreements (repos) | 0.15 | 0.10 | 0.10 | 0.10 | – | – |
| U.S. Treasury bills | – | – | 0.03 | 0.06 | 0.09 | 0.12 |
| Agency discount notes | 0.03 | 0.03 | 0.04 | 0.06 | 0.08 | 0.13 |
| LIBOR | 0.15 | 0.17 | 0.20 | 0.27 | 0.43 | 0.70 |
| Asset-backed commercial paper–First Tier | – | 0.20 | 0.21 | 0.28 | – | – |
| Dealer commercial paper–First Tier | – | 0.14 | 0.18 | 0.23 | – | – |
| Municipals–First Tier | 0.19 | 0.22 | 0.18 | 0.17 | 0.17 | 0.20 |
Sources: Bloomberg, L.P.; Wells Capital Management
Past performance is no guarantee of future results.
Sector views
Prime sector
The easy monetary policy adopted by global central banks in order to support economic growth continued to push credit spreads tighter and money market yields lower. At the same time, larger-than-expected tax receipts and the corresponding seasonal pay-down of U.S. Treasury securities added even more liquidity to the system, pressuring repo rates lower. With repo rates down, market participants scrambled to find investments to add diversification and incremental yield. Demand for investments continues to outweigh available supply, which is causing yields for the most favored countries and credits to fall even further. This excess demand for short-term investments can be observed in the flatter LIBOR (London Interbank Offered Rate) curve, as shown in the graph below.
LIBOR yield curve
Source: Bloomberg, LP
Past performance is no guarantee of future results.
In addition to the LIBOR curve flattening, the situation in Cyprus seems to have quieted down for now and Italy was finally able to form a government. As a result, five-year sovereign CDS spreads tightened back to pre-Cyprus crisis levels. The relatively muted reaction to the Cyprus crisis and prolonged Italian election can partly be attributable to central bankers' easy money policies.
5-year sovereign CDS, European peripheral countries
Dec-10 through Apr-13
Source: Bloomberg, LP
Past performance is no guarantee of future results.
Total commercial paper outstandings rebounded this month from quarter-end pressures that took some issuers out of the market for a period of time. The rebound was driven primarily by non-U.S. financial issuers and was led by issuers in Australia, Canada, and the Nordic region as investors searched for longer-term, high-quality commercial paper "lock in the yield pick up" that was available further out the curve.
U.S. commercial paper outstandings
(not seasonally adjusted)
Source: U.S. Federal Reserve
Past performance is no guarantee of future results.
While tax season puts downward pressure on repo rates, there is upward pressure on the rates and available inventory of variable-rate demand notes (VRDNs) as municipal funds see tax-related outflows. With rates in the high teens to low twenties, as measured by basis points, VRDNS were competitive compared with short-term bank deposits, allowing us to reallocate some of our liquid holdings from repo to VRDNs.
U.S. government sectorThe U.S. government securities market is participating in a time-honored ritual of bringing down yields as it deals with a contraction in Treasury bill (T-bill) supply. From time to time, the U.S. Treasury issues extra T-bills, usually in the form of cash management bills (CMBs), to meet its temporarily increased cash needs. This issuance most often coincides with tax collection flows, especially before the traditional income tax payment deadline of April 15. The net changes in T-bill issuance for 2012 and thus far in 2013 can be observed in the following chart.
Weekly net new Treasury bill issuance
Source: U.S. Treasury
Past performance is no guarantee of future results.
This year was no exception, as the Treasury issued $105 billion of CMBs in February and March, providing conservative money market participants with additional supply. The entire $105 billion matured over a 10-day period in late April, leaving investors with that much more liquidity to put to work. The effect of this supply contraction was felt across the spectrum of U.S. government securities products, from T-bills to repos to agency discount notes. The yield on 3-month T-bills, which averaged 9 bps from mid-February to mid-March and peaked at 11 bps, had fallen to 5 bps by the end of April. Treasury repo rates averaged 18 bps over the same period, and by the last full week of April, they fell to just 10 bps. Agency discount note yields saw similar declines.
In addition to the reduction due to the seasonal CMB cycle, T-bill supply has also been adversely affected by smaller regular weekly T-bill auctions. Recently, the Treasury had been conducting a weekly auction of $45 billion, $35 billion, and $30 billion of its 4-week, 3-month, and 6-month T-bills, respectively. By the last week of April, the size of these auctions had shrunk to $30 billion, $29 billion, and $24 billion, respectively. The reductions in the regular auctions came sooner and to a greater degree than many investors expected and may be due to unexpectedly larger cash balances at the Treasury. These, in turn, appear to be the result of higher tax collections. By late April, the Treasury's year-to-date "Individual Income and Employment Taxes, Not Withheld" totaled $291 billion, compared with $227 billion at the same time in 2012. These are mainly tax payments related to the previous tax year, and the increase may partly reflect income that was shifted into 2012 from 2013, perhaps as the result of special dividends paid late in 2012. Whatever the cause, the smaller weekly auctions, coming on the heels of the seasonal CMB maturities, are likely to continue to keep downward pressure on yields.
Municipal sector
The tax man cometh in April, bringing along alternating swings in supply and demand and causing a higher degree of interest-rate volatility in the short end of the money market space. Municipal money market funds experienced persistent outflows related to income tax payments throughout the period, which caused a gradual increase in inventory levels of tax-exempt VRDNs and tender option bonds (TOBs). This increase in supply exerted upward pressure on yields, which ultimately rose to levels last seen during the same tax-time period a year ago, attracting nontraditional buyers, such as our own prime money market funds, during the latter half of the month. Tax-exempt floating rates became increasingly attractive on a relative basis as unexpectedly high tax collections at the Treasury resulted in a decrease in T-bill supply and lower rates on taxable alternatives in the overnight and weekly markets. This resulted in a sharp increase in crossover buying of short-term municipal investments that relieved inventory pressures and limited the advance in tax-exempt yields near month-end.
Rates on overnight VRDNs and TOBs averaged roughly 0.17% for the month, up from roughly 0.11% for the month of March. In the weekly market, the Securities Industry and Financial Markets Association (SIFMA) Municipal SWAP Index1 steadily rose to 0.23% on April 17 before easing to 0.22% on the heels of a pickup in crossover buying. Further out the municipal money market curve, yields on commercial paper in the 30- to 90-day range backed up a few basis points to the 0.17% to 0.18% range. However, the municipal yield curve remained relatively unchanged and flat in the six-month to one-year range as demand has remained high and supply remained subdued.
The Treasury is not alone in reaping the rewards of higher tax rates and a slowly improving economy. According to the Rockefeller Institute, tax revenues at state and local levels have continued to recover as well. Overall, state tax revenues have increased for 12 consecutive quarters through the end of 2012, while preliminary estimates indicate double-digit gains for most states in the first two months of 2013 on a year-over-year basis. While we are pleased with the overall improvement in revenues, we remain cautious as changes in tax policies in 2012 may have temporarily accelerated collections in the early part of 2013. As always, we will continue to monitor the progress being made on both the revenue and expense sides of the book, and we remain confident that the prospects for municipal issuers will continue to slowly improve in the face of a sluggish macroeconomic environment and continued uncertainty surrounding the federal budget sequester.
On the horizon
Interest rates have fallen in the face of increased demand for and declining supply of money market instruments and as a relative calm prevails in the credit markets. Developments on the regulatory front could further exacerbate the supply situation. The uptick in municipal yields provided a bright note and opportunity for flexible investors. An easing of near-term supply pressures could lead to a bit of relief in the overnight markets. Regulatory efforts here and abroad continue to cloud the waters, and as the outcome of those efforts is more political than fundamental, the outcome is extraordinarily hard to predict. We remain vigilant in our assessment of the risk/reward trade-offs in these markets and advocates of a relatively liquid and short portfolio structure.
View current money market fund performance.
View a list of complete holdings for the money market funds.
1. The SIFMA Municipal SWAP Index, produced by Municipal Market Data (MMD), is a seven-day high-grade market index composed of tax-exempt variable-rate demand obligations from MMD's extensive database. You cannot invest directly in an index.
A portion of the Municipal Money Market Fund's income may be subject to federal, state, and/or local income taxes or the alternative minimum tax (AMT). Any capital gains distributions may be taxable. For the government money market funds, the U.S. government guarantee applies to certain underlying securities and not to shares of the fund.
The views expressed and any forward-looking statements are as of 4-30-13 and are those of the fund managers and the money market team at Wells Capital Management, subadvisor to the Wells Fargo Advantage Money Market Funds, and Wells Fargo Funds Management, LLC. Discussions of individual securities, or the markets generally, or any Wells Fargo Advantage Fund are not intended as individual recommendations. Future events or results may vary significantly from those expressed in any forward-looking statements; the views expressed are subject to change at any time in response to changing circumstances in the market. Wells Fargo Funds Management, LLC, disclaims any obligation to publicly update or revise any views expressed or forward-looking statements.
