Although most experts don’t think negative interest rates are likely, the fund industry recently began making its pitch to regulators for what to do just in case.
Reverse distributions–a paradoxical term that sounds almost Orwellian, like “war is peace”–are exactly what the Investment Company Institute, a fund trade group, describes in a December report about money-market funds. The report was meant to address concerns that U.S. money funds won’t be able to maintain even zero yields after deducting their fees in a negative interest-rate environment—as has been the case in Europe since 2014.
How can distributions you’re supposed to receive work in reverse? The ICI’s paper describes a process in which instead of getting an income payment, a reverse distribution mechanism, or RDM, “distributes a [constant net asset value or] CNAV money-market fund’s negative yield by canceling shares in shareholder accounts. It offsets the daily negative yield accrued (i.e., a decline in the fund’s net assets) by reducing the number of fund shares outstanding. This process allows the fund to maintain a constant NAV per share, typically $1.00.”
In Europe, reverse distributions are called the much less appealing but more straightforward “share destruction” or “share cancellation.” Those terms describe exactly what will happen.
The $1 NAV has been sacrosanct in U.S. money-market funds for retail investors since their creation in 1971, enabling investors to think of money-market funds like bank accounts, even though they’re not federally insured. The handful of times money-market funds have “broken the buck” have been during periods of extreme market stress, the last being the Reserve Primary Fund’s falling to 97 cents in 2008 because of the Lehman Brother’s bankruptcy.
RDMs create the illusion that investors aren’t losing money by preserving the $1 NAV while share count declines. The purpose though isn’t to deceive investors but to prevent NAVs from declining below $1 from fee and yield erosion in a negative-rate environment. “In the current [zero interest rate] environment, [money funds] are waiving more than half of their fees,” says Peter Crane, president of money fund tracker Crane Data. “So instead of charging [0.28%], they’re charging [0.13%] currently.”
Some money managers say maintaining a $1 NAV, even if share counts decline, is easier for brokers that sell funds to keep track of when they sweep cash in and out of funds every day. “When you sweep [cash] at the end of each day, sweeping into a stable net asset value product, it’s pretty easy, because it’s just a dollar in a dollar out,” says Deborah Cunningham, CIO of Global Liquidity Markets at Federated Hermes, which manages $433 billion in money market assets and contributed to the ICI’s report along with other money market managers. “On that sweep mechanism, there are no calculations of shares versus price, whereas pretty much any other mechanism, you would need to do that shares versus price calculation.”
Yet there is also a psychological dimension to preserving the $1 NAV as opposed to allowing it to fluctuate or “float” like a normal stock or bond fund. “Our investor clients want a constant NAV solution,” says Jeff Weaver, a senior portfolio manager overseeing some $200 billion of money-market funds at
Asset Management, which also contributed to the ICI’s report. “They don’t want a floating NAV.”
Still, institutional municipal debt and prime money-market funds already have floating NAVs that can fall below the $1 mark because of a 2016 regulatory change. Weaver says Wells Fargo’s institutional clients would rather that not be the case: “Clients in money-market funds are looking to preserve principal. If an NAV is fluctuating, then there’s a possibility that they lose principal.”
Weaver compares the ICI’s report on RDMs to an “emergency preparedness plan,” as the likelihood of negative interest rates occurring in the U.S. is “very remote.” While Treasury bills briefly dipped into negative yield territory during the pandemic crash last March, the U.S. has been in recovery mode since.
The coronavirus remains an economic wild card, however. The Federal Reserve Bank “has said they do not want to go negative, but you never say never,” Crane says. “You get another huge shock to the economy to push us back down, and all of a sudden, negative rates and deflation could be a possibility, again.”
There could also be regulatory hurdles for RDMs. When European rates went negative in 2014, some funds such as BlackRock ICS Euro Government Liquidity Fund employed RDMs, which the ICI’s RDM design resembles. Ultimately, EU regulators banned RDMs in 2018, stating they were not “compatible” with existing regulations and funds had to shift to floating NAVs.
So, if the RDM scenario is unlikely in 2021, why did the ICI publish a report detailing it at the end of 2020? One reason was to publicly make the RDM case. The ICI’s “putting this out there not only for people in the industry and their clients but also for the regulators themselves to help understand [RDMs] could work,” Weaver says. The other was client concern. “The topic of negative rates was so persistent through last year from the beginning [of the pandemic crisis] in March, you couldn’t have a conversation with a client or colleague without a discussion about [it].”
Certainly, if RDMs were to happen, educating investors would be challenging. “This is something that would be new to most investors, especially retail investors,” acknowledges Jeff Naylor, the ICI’s director of operations and distribution. “We do highlight in the paper, the need for a communication strategy for both the funds and the intermediaries.”
One thing that might help clarify things is to not call them RDMs, but share destruction instead. That would be less Orwellian.
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