Portfolio Manager Commentary
Overview, strategy, and outlook: As of February 28, 2018
Focus on markets and regulation
Viva Las Vegas!
The Structured Finance Industry Group held its 2018 conference in Las Vegas from February 25–28. While modest relative to other industry conventions, with well over 7,000 attendees the event remains the largest structured finance conference in the world, drawing professionals from rating agencies, issuers, dealers, the investing and legal communities, and other participants in the structured finance marketplace.
The optimism on display at last year’s conference largely carried over to the conference this year, given the continued strong credit and market environments. In addition to conversations about credit, themes from this year’s conference included the impacts of easing regulation, tax reform, and benchmark, as well as the continued maturation of less-established securitized asset classes.
Using Asset-Backed Alert rankings, issuance volume in worldwide structured finance was $781.4 billion in 2017, up 25% from $622.7 billion in 2016. The higher issuance was driven by a number of categories, including a $50 billion increase in collateralized loan obligation (CLO) issuance year over year; $30 billion more in U.S. commercial mortgage-backed securities (CMBS) volume; and a $43 billion increase in private placement (144A) U.S. asset-backed security (ABS) volume, reflecting growth of some of the less-mature asset classes. In the commercial paper market, as of February 28, the amount of asset-backed commercial paper (ABCP) outstanding as tracked weekly by the Federal Reserve (Fed) currently stands at $240.5 billion, versus $246.9 billion a year ago (not seasonally adjusted). Looking forward, expected 2018 volume for U.S. ABS, excluding CLOs and CMBS, appears to be similar to, if not slightly lower than, 2017, with continued shifts in composition as asset classes other than credit cards and autos become a larger portion of the mix. However, higher-than-expected increases in rates may slightly pressure forecasted volumes and credit. The ABCP market remains well anchored with liquidity from large, internationally active banks funding assets such as trade receivables or assets ultimately placed in the term ABS market.
Issuers and investors largely have implemented many of the crisis-driven regulatory changes addressing capital, liquidity, and securitization standards, including some still in the pipeline, and they now may be able to shift their focus as they enter an environment that seems to be marked by an easing of some of those very same regulations. Congress, the U.S. Department of the Treasury, and the Fed have multiple work-streams to modify banking and capital market regulations, and additional changes may come from other sources, such as the courts. For example, the recent decision by the U.S. Court of Appeals to exempt CLO managers from Dodd-Frank’s risk-retention requirements was viewed as a positive for the business and may spur other sectors to seek relief, although it is not clear how issuance volume may be affected in other sectors to the extent relief does not occur.
Regarding banking regulations, the Fed is looking at modifications to the supplementary leverage ratio that could potentially free up bank balance sheets for lending by excluding cash from the denominator, which would be welcomed by market participants and banks. Congress is reportedly considering a measure to increase the threshold for determining whether a bank is systemically important from $50 billion to $250 billion. And the Treasury has several recommendations regarding banking, capital markets, insurance, and asset managers, including recommendations to ease Volcker Rule restrictions and to permit structured finance products to be treated more favorably for liquidity coverage ratio purposes by making them eligible for inclusion as a level 2B high-quality liquidity asset. On the other hand, despite bipartisan support, the conversation noticeable in its absence was a discussion of the bills in Congress that would allow prime money market funds to move back from the floating net asset value (NAV) construct mandated by the SEC’s 2014 amendments of 2a-7’s money market rules to the former widely-used constant NAV structure. In sum, however, despite the steady swings of the regulatory pendulum on many fronts, the ABS market, including ABCP, has remained stable and relatively robust. While the U.S. is experiencing some regulatory easing, that is not the case for all jurisdictions. Some non-U.S. ABCP issuers expressed concern about increases in capital requirements that will enter into force beginning in 2019. This may prompt issuers to increase pricing and/or restructure transactions.
Benchmark reform also was a topic of conversation. Replacing the London Interbank Offered Rate (LIBOR) with a new benchmark presents a sizable task on a number of different fronts. Participants were particularly focused on ensuring that the economics of legacy transactions are not skewed to benefit one party, at the expense of another, upon transition to the new index. Presently, it is a challenge to compare the current benchmark with the proposed, and adding to the difficulty in this analysis is the fact that there is no curve yet available for a proposed benchmark. Language in the documents for existing transactions, some of which go back many years, often did not adequately contemplate the end of the benchmark, and this will need to be addressed for those transactions that do not mature before the transition date. To that end, acceptable replacement language where needed in transaction documents for existing and new transactions has not been agreed upon to a consistent market standard. As the 2021 implementation date nears, these and other tasks create a sense that the market has significant milestones to reach before a change is possible. Some issuers even stated that they believe the implementation could be delayed as a result of the complexity of building a replacement benchmark out the curve. It may be a bumpy path.
Speculation on the impacts of tax reform signed into law in December 2017 was a frequent discussion. Corporations still appear to be evaluating both how their business operations may change and what changes might take place with their investment portfolios. While much speculation abounds on where flows may migrate, the consensus was that it may be too soon to draw concrete conclusions on how the investing space might be altered.
Even as the Treasury employed extraordinary measures to fund the government, for the second consecutive debt-ceiling cycle Congress was able to resolve the issue by suspending the debt ceiling several weeks before the government’s cash store would have begun to run dangerously low; this might be a benefit of a unified government. The debt ceiling now is suspended until March 2, 2019, when it will be reinstated at the amount of debt then outstanding. Between now and then, the government can issue all of the debt it wants, which is convenient because it wants to issue a lot. The tax cut passed in December and the budget bill that accompanied the debt-ceiling suspension both point to an expanding federal deficit for the foreseeable future, which will need to be funded by issuing more debt.
With the shackles off and the need acute (due to the usual first-quarter tax refund outflows), the Treasury reacted by bumping up its Treasury bill (T-bill) auction sizes, with the result being an increase of $111 billion in T-bill supply in the last half of February, with more to come in March. Higher yields in the T-bill market have followed, as the market tries to digest the additional supply just as it is trying to price in an expected interest-rate hike by the Fed in March. After years and years of zero interest rates, money market investors find themselves venturing wide-eyed into unfamiliar territory.
The impact of the additional supply can be seen in the chart below that shows the spread of 3-month T-bill yields over the Fed’s reverse repurchase agreement program (RRP) rate, which anchors the bottom of its overnight interest-rate range, over the roughly 3 months preceding an expected Fed rate hike. That spread generally rises as the anticipated hike gets reflected in T-bill prices. On average, the market during the run-up to the first four hikes in this cycle failed to price in the entire 0.25% hike until it actually occurred. For the most recent hike in December 2017, yields captured the 0.25% raise four weeks before it happened. By comparison, yields in the current market have been running about 0.10% higher than for the December hike, and the entire rate hike was priced in six weeks before the Fed meeting.
Excess of 3-month T-bill yields over RRP
Source: Bloomberg L.P.
On the horizon
Changes on the fiscal front, with tax cuts and increased spending likely to spur the economy and swell the deficit, are taking place concurrently with monetary policy uncertainty, both in the makeup of the Fed and in its shift from crisis-era maximum accommodation to normalization. And markets have noticed. After spending last year getting acclimated to a Fed hiking cycle, the money markets have handled February’s supply surge relatively smoothly, with investors welcoming the higher yields. Other financial markets, nearly without exception, have seen a marked increase in volatility as they grapple with newly awakened market forces. Crisis management had been the name of the game for nearly a decade, and as central banks step back and fiscal authorities ease some restrictions, it seems as though markets may be free to chart their own messy course. As for the Fed, so far its new voices sound like its old ones. Its normalization path seems set, with a systematic balance sheet wind-down underway combined with quarterly rate hikes, but the combination of a new cast of characters, not only in the leadership but also throughout the board and regional districts, with a robust economy and a pulsing new fiscal policy makes the monetary policy path uncertain.
Wells Fargo FNAV money market fund NAVs
Source: Wells Fargo Funds
Wells Fargo FNAV money market fund weekly liquid assets
Source: Wells Fargo Funds
Rates for sample investment instruments—Current month-end % (February 2018)
|Sector||1 day||1 week||1 month||2 month||3 month||6 month||12 month||Wells Fargo Fund||7 day current yield|
|U.S. Treasury repos||1.37||1.37||–||–||–||–||–||Cash Investment MMF*–Select||1.58|
|Fed reverse repo rate||1.25||–||–||–||–||–||–||Heritage MMF*-Select||1.56|
|U.S. Treasury bills||–||–||1.47||1.53||1.63||1.81||2.00||Municipal Cash Mgmt MMF*–Inst'l||1.03|
|Agency discount notes||1.20||1.25||1.42||1.56||1.64||1.73||1.98|
|Asset-backed commercial paper||1.41||1.47||1.68||1.89||2.03||2.23||–||Treasury Plus MMF**-Inst'l||1.22|
|Dealer commercial paper||1.45||1.47||1.57||1.73||1.87||2.02||–||100% Treasury MMF**-Inst'l||1.28|
Sources: Bloomberg L.P., Wells Capital Management, Inc., and Wells Fargo Funds
Figures quoted represent past performance, which is no guarantee of future results, and do not reflect taxes that a shareholder may pay on a fund. Yields will fluctuate. Current performance may be lower or higher than the performance data quoted and assumes the reinvestment of dividends and capital gains. Current month-end performance is available at the funds’ website, wellsfargofunds.com.
Money market funds are sold without a front-end sales charge or contingent deferred sales charge. Other fees and expenses apply to an investment in the fund and are described in the fund’s current prospectus.
The manager has contractually committed to certain fee waivers and/or expense reimbursements. Brokerage commissions, stamp duty fees, interest, taxes, acquired fund fees and expenses, and extraordinary expenses are excluded from the cap. Without these reductions, the seven-day current yield for the Institutional Class of the Cash Investment Money Market Fund, Heritage Money Market Fund, Municipal Cash Management Money Market Fund, Government Money Market Fund, Treasury Plus Money Market Fund, and 100% Treasury Money Market Fund would have been 1.45%, 1.43%, 0.93%, 1.21%, 1.20%, and 1.08 %, respectively, and the total returns would have been lower. The cap may be increased or the commitment to maintain the cap may be terminated only with the approval of the Board of Trustees. The expense ratio paid by an investor is the net expense ratio (the total annual fund operating expenses after fee waivers) as stated in the prospectus.
*For floating NAV money market funds: You could lose money by investing in the fund. Because the share price of the fund will fluctuate, when you sell your shares they may be worth more or less than what you originally paid for them. The fund may impose a fee upon sale of your shares or may temporarily suspend your ability to sell shares if the fund’s liquidity falls below required minimums because of market conditions or other factors. An investment in the fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The fund’s sponsor has no legal obligation to provide financial support to the fund, and you should not expect that the sponsor will provide financial support to the fund at any time.
For retail money market funds: You could lose money by investing in the fund. Although the fund seeks to preserve the value of your investment at $1.00 per share, it cannot guarantee it will do so. The fund may impose a fee upon sale of your shares or may temporarily suspend your ability to sell shares if the fund’s liquidity falls below required minimums because of market conditions or other factors. An investment in the fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The fund’s sponsor has no legal obligation to provide financial support to the fund, and you should not expect that the sponsor will provide financial support to the fund at any time.
**For government money market funds: You could lose money by investing in the fund. Although the fund seeks to preserve the value of your investment at $1.00 per share, it cannot guarantee it will do so. An investment in the fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The fund’s sponsor has no legal obligation to provide financial support to the fund, and you should not expect that the sponsor will provide financial support to the fund at any time.
For the municipal money market funds, a portion of the fund’s income may be subject to federal, state, and/or local income taxes or the alternative minimum tax. 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 February 28, 2018, and are those of the fund managers and the Money Market team at Wells Capital Management, subadvisor to the Wells Fargo Money Market Funds, and Wells Fargo Funds Management, LLC. Discussions of individual securities, the markets generally, or any Wells Fargo Funds 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.
Carefully consider a fund’s investment objectives, risks, charges, and expenses before investing. For a current prospectus and, if available, a summary prospectus, containing this and other information, visit wellsfargofunds.com. Read it carefully before investing.