Portfolio Manager Commentary
Overview, strategy, and outlook: As of November 30, 2013
On November 6, the U.S. Treasury announced it would conduct its first auction of floating-rate notes (FRNs) on January 29, 2014. This is a notable event because it is the Treasury’s first new product in 17 years. The FRNs will have a maturity of two years and an interest rate that resets daily based on the most recent 13-week Treasury bill (T-bill) auction rate plus or minus a spread that is set at the auction. The first auction is expected to be for an amount of $10 billion to $15 billion, with additional sales of the same issue, called reopenings, at the end of each of the next two months, for a total issue size of perhaps $40 billion. This auction schedule would allow for four distinct maturities, totaling in excess of $150 billion, to be issued each year.
There will be a period of price discovery in the initial auctions, as some investors seek an early-adopter discount while others may wait for the dust to settle before becoming involved. Buyers are expected from the usual population of T-bill and other short-term Treasury investors, including money market funds, central banks, and entities needing high-quality liquid assets (HQLA) to meet the various upcoming regulatory requirements we discussed in last month’s commentary.
This leads to an important realization about the FRNs: despite being new and exciting, they aren’t likely to significantly change either the supply or demand dynamic in U.S. government money markets. As mentioned above, the demand from buyers who want, or need, to own Treasuries will continue to be robust. On the supply side, the Treasury’s total issuance is always based on its cash needs, meaning the cash raised by issuing FRNs will come at the expense of issuing other instruments. Given the Treasury’s drive to extend the average maturity of the country’s debt during this post-financial crisis period of heavy deficits, FRN issuance seems most likely to replace T-bill issuance. This brings up the interesting point that the Treasury has the opportunity to influence the 13-week T-bill auction rate by shrinking the auction size. Investors could pick up additional yield in the FRNs’ spread to the index but give some yield back down the road as the index may be lower than it otherwise would be due to a scarcity of T-bills.
When it all shakes out, FRNs will probably be yield-positive for investors who buy them in lieu of T-bills. FRNs are a longer-term instrument than the T-bills they replace, so they should yield more. As a risk-free instrument, credit shouldn’t be a concern, but gauging the correct yield spread for two years will be more challenging. On that note, the Continuing Appropriations Act, 2014 suspended the debt limit for the U.S. until February 7, 2014, just one week after the first FRNs are due to settle. Depending on the temperature of the topic in the news at that time, this may affect the initial FRN auction as well. Questions about creditworthiness could lead some to avoid the auction, but conversely, the FRNs could be seen as more desirable than T-bills as their final maturity is far in the future, long past any political wrangling from the current episode.
Although these new FRNs won’t materially change the supply/ demand dynamic, for investors who are limited by their charters to investing in U.S. Treasury obligations, this new product is, in fact, pretty exciting. For Treasury-only money market funds, this is very friendly for the weighted average maturity (WAM),1 which is limited to 60 days, because the interest-rate reset of one day allows them to mark the maturity in a corresponding manner for this calculation, which will push a fund’s WAM lower. A constraining effect, however, is the FRN’s final maturity of two years, which will push a fund’s weighted average final maturity (WAFM)2 much higher. With a fund’s WAFM capped by SEC Rule 2a-7 at 120 days, this means a fund could only put a maximum of 16% of its assets in two-year FRNs if the rest of the fund was strictly in overnight investments. Given these factors, Treasury-only funds are likely to want to buy the FRNs for additional yield and their lowering effect on WAM but will be limited to a fairly small involvement due to the WAFM restrictions. Prime funds and government funds able to invest in more than just Treasuries are likely to be less motivated to buy the FRNs given their access to higher-yielding alternatives.
Shareholder flows and yield volatility quieted down this month in the prime money market space after October’s fiscal follies. Market participants focused their attention on deploying the liquidity they had built up during the so-called crisis by investing over the turn of the year in an effort to position portfolios into 2014. In a seasonal ritual, the supply of money market product tends to decrease leading into year-end, putting downward pressure on yields. According to Federal Reserve (Fed) statistics, between October 30 and November 27, the total amount of commercial paper (CP) issued with maturities in 2014 jumped from 33% to 53.4% of all outstanding CP. Additionally, the term of the new issuance has tended to be longer than it has in the past. The table below shows the dollar amount of maturities in the weeks following year-end. Compared with previous years, investors are showing a preference for 10- to 14-week maturities, at the expense of shorter maturities.
Weekly pattern of CP maturities after December 31
Source: Federal Reserve
Past performance is no guarantee of future results.
With year-end supply pressures weighing on the short end and the front end of the yield curve flattening, many market participants have been focused on longer-dated maturities, providing high-quality issuers with longerdated funding at attractive yields. The total supply of CP outstanding has been relatively constant throughout the year, with only the composition of new issuance changing between financials and nonfinancials sectors and shorter versus
U.S. commercial paper outstanding
(not seasonally adjusted)
Source: Federal Reserve
Past performance is no guarantee of future results.
The debate among market observers continues about whether the Fed will begin to taper its current $85 billion-per month purchases of Treasury and mortgage-backed securities at the conclusion of the December 18 FOMC meeting or at some point during the first quarter of 2014. When tapering actually occurs, this will no doubt lead to a repricing of various asset classes. However, the Fed has taken steps to try to soothe these sentiments by communicating that tapering is still an accommodative policy and is separate from tightening monetary policy through measures such as explicitly raising its federal funds target rate (currently between 0.00% and 0.25%). As a result, the federal funds futures market currently has the first rate increase priced in November 2015. Barring another credit event, we expect to see some further flattening of the money market yield curve.
November offered a welcome respite from the daily political drama and market volatility experienced during the tense U.S. debt ceiling debate in Washington the previous month in the municipal markets as well. As a sense of normalcy returned to the money markets, rates in the short end of the municipal space returned to the low single digits based on steady demand and lackluster supply. Demand for highgrade tax-exempt securities has been resilient, as municipal money market fund assets have continued to stabilize over the past few months. Meanwhile, supply continues to be a challenge as issuance in the municipal money market space experienced another double-digit decline on a year-over-year basis this month.
Rates for sample investment instruments
Current month-end % (November 2013)
|Sector||1 day||1 week||1 month||2 month||3 month||6 month||12 month|
|U.S. Treasury repurchase agreements (repos)||0.08||0.05||0.06||–||0.08||–||–|
|U.S. Treasury bills||–||–||0.06||–||0.06||0.09||0.12|
|Agency discount notes||0.04||0.04||0.05||0.07||0.08||0.11||0.16|
|Asset-backed commercial paper—First Tier||0.15||0.15||0.15||0.18||0.22||–||–|
|Dealer commercial paper—First Tier||0.11||0.11||0.13||0.16||0.18||0.29||–|
Sources: Bloomberg L.P., Wells Capital Management
Past performance is no guarantee of future results.
In the daily and weekly markets, demand for high-grade variable-rate demand notes and tender option bonds remained strong, pushing yields on these securities from the low teens in mid-October to the 0.05% to 0.08% range for most of November. In the weekly market, the Securities Industry and Financial Markets Association (SIFMA) Municipal Swap Index3 finished the month at 0.05%, its lowest level since early September. As yields in the daily and weekly sectors have hovered at rock-bottom levels, demand for higheryielding longer-dated commercial paper and notes continued to grow. We have also observed increased demand for the very limited supply of high-grade notes in the six-month and one-year space, where yields have continued to compress. With limited primary market activity to provide guidance, the one-year high-grade benchmark yield fell to a year-to-date low of 0.17% on strong secondary market activity.
While we have extended maturities somewhat in the face of persistently low short-term rates for the foreseeable future, we continue to feel that the asymmetrical risk/reward dynamic present in this low-yield environment warrants a relatively conservative approach with an emphasis on liquidity in our portfolios.
On the horizon
As we prepare to close the books on 2013, we look forward to 2014 and the challenges that await us. New types of instruments, the potential for a beginning of a shift in Fed policy, new regulations, and continuing developments on the credit front will all present their unique challenges. Our aim is to continue to assess those risks and the rewards in the markets, and construct money market fund portfolios that will be resilient in the face of these challenges.
We wish you and yours a happy holiday season, and a safe and prosperous new year.
1. Weighted average maturity (WAM) is an average of the effective maturities of all securities held in the portfolio, weighted by each security’s percentage of total investments. The maturity of a portfolio security is the period remaining until the date on which the principal amount is unconditionally required to be paid, or in the case of a security called for redemption, the date on which the redemption payment is unconditionally required to be made. WAM calculations allow for the maturities of certain securities with demand features or periodic interest-rate resets to be shortened. WAM is a way to measure a fund’s sensitivity to potential interest-rate changes.
2. Weighted average final maturity (WAFM) is an average of the final maturities of all securities held in the portfolio, weighted by their percentage of total investments. The maturity of a portfolio security is the period remaining until the date on which the principal amount is unconditionally required to be paid, or in the case of a security called for redemption, the date on which the redemption payment is unconditionally required to be made. The calculation of WAFM allows for the maturities of certain securities with demand features to be shortened but, unlike the calculation of WAM, does not allow shortening of the maturities of certain securities with periodic interest-rate resets. WAFM is a way to measure a fund’s potential sensitivity to credit spread changes.
3. 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 11-30-13 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.