Money market funds are supposed to be ultra-safe, but new provisions have popped up in recent years that can make it difficult for holders of variable-rate and short-term securities to interpret and monitor.
The National Federation of Municipal Analysts seeks to remedy the problem with new guidelines aimed to improve disclosure and protect bondholders.
The guidelines, published in draft form Tuesday, are an update to a current set of best practices distributed in 2003, when variable-rate demand note issuance was surging. Today, VRDN issuance is roughly a quarter of 2009 levels, but liquidity facilities backing the securities are expiring at a record clip.
The NFMA thought it was time for an update. It is seeking comments on the
VRDNs are long-term bonds with short-term, floating interest rates. The notes have a tender option that can be exercised on a daily, weekly, monthly or quarterly basis, depending on the structure. Typically the note is backed by a liquidity provider, such as a bank, so investors aren’t reliant on the municipal issuer.
Money market funds are the primary buyers of VRDNs. Investors treat these funds like checking accounts: they must be able to deposit and pull money from them almost instantly to take advantage of market opportunities. Unlike checking accounts, funds aren’t hindered by deposit insurance fees, but they also aren’t insured and must carry negligible risks.
Rule 2a-7 of the Securities and Exchange Commission dictates that money market funds may only purchase securities rated in the two highest short-term rating categories. Securities must also meet “minimal credit risk” requirements and diversification mandates with respect to security structure, portfolio diversification, effective maturity and credit quality.
A number of changes in disclosure statements have troubled money market fund officials in recent years.
Among letters of credit — an irrevocable liquidity facility provided by banks — one such change is a conflict with respect to the tender mechanics associated with how bondholders are paid when they tender their bonds, according to Karen Flores, a managing director at Charles Schwab who co-chaired the draft.
“The paper includes refinements to the tender mechanics to ensure that the bondholder is only being paid from the bank and isn’t exposed to risks from another party that steps in, in between the payments,” Flores said on a conference call.
Another problem is the inconsistency of remedies associated with a bank failure. That wasn’t much of a concern in 2003, but the downfall of some Wall Street titans has changed that forever.
“In many instances it’s not clear that there is any recourse,” Flores said. “This is especially important because although the bondholder is buying the bond backed by the LOC, the bondholder is not a party to the letter of credit and therefore doesn’t have any direct access to the bank.”
The NFMA recommends disclosure include a description of bondholder rights against the bank for non-payment, including the right to direct the trustee to seek recourse on their behalf.
Another key observation was certain procedural difficulties with respect to substituting liquidity providers.
According to a presentation at the Securities Industry and Financial Markets Association earlier this month, outstanding liquidity support for VRDNs is upwards of $360 billion. More than half of those supports expire in 2011 or 2012, and banks are competing to renew the facilities, convert the notes to fixed-rate bonds, or buy them as a direct purchase.
When renewals from new banks take place, the NFMA recommends a simple solution: mandatory tender with the right to retain. In other words, funds would be notified that the liquidity provider has changed and they would have an opportunity to get their money back or review the new terms and reinvest.
Among standby purchase agreements — a liquidity structure whereby a bank agrees to purchase VRDNs if a remarketing fails — a major concern is full disclosure of termination events.
Unlike an irrevocable LOC, a standby purchase agreement can include walk-away rights, which grant the bank the right to terminate the contract and potentially leave the long-term bond in the hands of a short-term fund.
This can be disastrous, though it can occur only in “true, major cliff events,” according to Ben Schuler, analyst at Fidelity and co-chair of the study.
“It’s vital that these walk-away events are clear and known,” Schuler said. “The disclosure of these events is very important and events must be made with great specificity. To the degree that these events are open to interpretation, it opens up the concept of, 'maybe we don’t know what some of these events are.’ ”
The new guidelines should be viewed as a floor, not a ceiling, the NFMA said.
“Improved disclosure is in the interests of all market participants, as it should expand the investor base and improve liquidity.”
