OREANDA-NEWS. April 20, 2015. A new money market fund structure, proposed as a compromise between constant and variable net asset value funds, may face challenges in maintaining high diversification due to the growing scarcity of high-quality short-term investments, Fitch Ratings says. This could make it harder for these funds to achieve and maintain 'AAAmmf' ratings than for other MMF structures.

The new class of MMFs, low-volatility net asset value (LVNAV), has been proposed by the European Parliament's Committee on Economic and Monetary Affairs and will be put to the full parliament at end-April. It allows an MMF to issue and redeem units at a constant net asset value (CNAV) as long as this is within 20bp of its actual NAV, based on the amortised cost accounting approach for assets maturing within 90 days. All other assets must be valued using market or model prices.

To maintain their stable NAV, funds that chose to operate as LVNAV would have incentives to maintain most, if not all, their portfolio in assets with remaining maturities shorter than 90 days, as investment in longer-dated assets could introduce greater mark-to-market price volatility. High portfolio liquidity at one and seven days is also imposed by the proposed regulation.

We believe managing a fund under these investment guidelines in the current market environment would be challenging due to the growing scarcity of high-quality investment opportunities below three months. This could make it harder for an LVNAV fund to keep its exposure to a single issuer below the maximum concentration levels set forth in Fitch's criteria for 'AAAmmf' ratings, or those required by the proposed regulations.

The scarcity of short-dated assets largely results from Basel III, which discourages banks from obtaining short-term funding, constraining supply for money funds and other cash investors. Bank assets represent a large portion of European money funds, above 70% of portfolio assets in the past two years. This proportion has been declining, however, and reached a two-year low at end-2014, primarily due to supply constraints.

Money funds may be able to find suitable alternative investment opportunities with corporates and sovereign securities, but eligible supply below three months, which LVNAV funds would probably need, remains limited. Our criteria for a 'AAAmmf' rating includes a maximum of 10% exposure to a single issuer with an 'F1+' or 'F1' Short-Term IDR, of which no more than 5% can be greater than seven days. Exposure to issuers rated 'F2' or below is not compatible with a 'AAAmmf' rating.

The low-yield environment, particularly acute in euros, adds to the challenge of managing a portfolio of ultra-short-dated assets, which may make LVNAV less appealing to investors. Managers would probably not be able to use longer-dated assets to balance the ultra-low yield of very short-dated assets they would need to hold to meet liquidity requirements. Market yields will eventually rise, which could lessen this effect in the longer term. Yields could also look more attractive if there is significant demand for government-only funds which, as proposed, will continue to operate as CNAV funds. This is because "prime" spreads could widen and make LVNAV funds more economically feasible.

Similar issues face fund managers in the US, who may continue to offer 60-day-or-less money funds, applying amortised cost accounting, even after reforms take effect in 2016. As in Europe, there are questions about the challenges for these funds and whether shifts to CNAV government-only money funds will drive spreads wide enough to make the product economically attractive.

The introduction of LVNAVs will depend on whether the proposal is agreed by the parliament and the European Council. If they are introduced, it is unclear how many funds would decide to operate as LVNAV because of the restrictions. The proposals would also initially only authorise LVNAV funds for five years, creating the possibility that the structure would be temporary. This could put off both fund managers and potential investors.