 |
|
||||
| Home | News | Help Desk | Membership | Library | About |
|
| Library | |
 |
|
| Stable Times | |
| Papers | |
| Fee Disclosure Template | |
| Key Principles | |
|
Home > Library > Stable Times > Volume 3, Issue 1  The quarterly publication of the Stable Value Investment Association First Quarter 1999 • Volume 3 Issue 1 Funding Agreements in Money Market FundsBy Brian R. Carosielli and Jennifer F. Williams, Fitch IBCA Janet D. Olsen, of Bell, Boyd, & Lloyd assisted in the preparation of this report. Summary The pace of innovation in money market investments has increased in recent years, leading to a proliferation of products and a complex array of investment choices. At the leading edge of this innovation are funding agreements. Consequently, money market fund portfolio managers are increasingly offered funding agreements for potential investment. Professionals in the mutual fund industry have debated the appropriateness of funding agreements as eligible money market investments under Rule 2a-7 since money funds first invested in funding agreements. Often, fund managers are apprehensive of investing in new products, since the instruments have not yet been tested during adverse market conditions. Some portfolio managers have approached funding agreements cautiously due to concerns regarding liquidity, credit exposure, and inconsistent regulation among states. Proponents of funding agreements argue that they are stable, liquid investments that offer attractive risk-adjusted returns. In this report, Fitch IBCA examines the suitability of funding agreements as money market fund investments within the context of Rule 2a-7 eligibility standards and Fitch IBCA money market fund ratings guidelines. Background Funding agreements are contracts issued by insurance companies (the issuers) that provide the policyholder with the right to receive a fixed or variable rate of interest and the full return of principal on the maturity date. The market for funding agreements consists primarily of nonqualified institutional investors, as defined under the Employee Retirement Income Security Act (ERISA) of 1974, that purchase the contracts directly from insurance companies or brokers. The National Association of Insurance Commissioners (NAIC), as well as many state guaranty funds, have classified funding agreements as insurance policies; therefore, the policies are regulated under state insurance laws. As with all insurance products, funding agreements do not have to be registered with the Securities and Exchange Commission (SEC) under the Securities Act of 1933. Funding agreements were developed by insurance companies as a means to maximize their existing guaranteed investment contract (GIC) underwriting expertise and distribution capabilities. In a GIC market that has been characterized by increased competition and declining sales, funding agreements have provided insurance companies with an additional source of revenue. A GIC can be defined as a benefit-responsive contract that is issued to a tax-qualified pension plan, as defined by ERISA, that guarantees an interest-crediting rate for a specified period. Funding agreements and GICs have similar characteristics, but funding agreements differ in two fundamental ways: 1) they are sold to nonqualified institutional investors; and 2) they include embedded demand features. A majority of the funding agreements sold are highly customized to meet money market fund investor preferences. For example, an investor in a variable-rate funding agreement can choose from a myriad of appropriate money market indexes that are used to determine the interest-crediting rate, including: one-month, three-month, six-month, or 12-month London Interbank Offer Rate (LIBOR); Fed funds; and the one-year Constant Maturity Treasury Index (CMT). In addition, funding agreements that are purchased by money market funds typically include embedded demand features, which entitle the policyholder to receive principal in a defined number of days after giving notice to the issuer. Money market funds may choose from seven-, 30-, 90-, 180-, 365-, or 397-day demand features. Several money market funds also customize their extension agreements, day of interest rate reset, and policies regarding issuer downgrades. According to the Investment Company Institute, money market fund assets increased from $1,055.93 billion at Nov. 30, 1997 to $1,357.22 billion at Nov. 30, 1998 (see net assets chart). Over a similar period, a Townsend & Schupp Co. survey of insurance companies estimated that there was $16.25 billion of new funding agreement issuance for calendar year 1997 and $21.93 billion of new issuance for the first nine months of 1998 (see funding agreement sales chart). An estimated 35.7%, or $7.83 billion, of all new 1998 funding agreement sales was to money market funds (see Distribution of Funding Agreement Sales by Market Segment chart). This $7.83 billion of new issuance in 1998 represents close to a 9% increase over 1997 sales to money market funds. Townsend & Schupp has also approximated that, as of the first nine months of 1998, the amount of funding agreements outstanding was $44 billion. With rapid growth and increased competition in the money market fund industry, elevated demand for funding agreements should continue. Reasons for Investment Because of a flattening of the U.S. Treasury yield curve over the past two years, most money market fund managers have been actively seeking investments that will increase portfolio yield without adding supplementary risk. Funding agreements have become one of the fastest growing asset classes in several money market funds because of their attractive yields. Traditionally, funding agreements have offered yields that are, on average, 15 basis points higher than similarly rated commercial paper or other variable-rate instruments. Portfolio managers have also been enticed by the diversification benefits that funding agreements offer. Since most insurance companies do not issue commercial paper, funding agreements allow money market funds to receive credit exposure to the insurance industry (in particular, mutual insurance companies). In addition, funding agreements allow for a high degree of contract customization, which creates the opportunity for portfolio managers to build a security that meets their investment criteria and desired risk profile. Furthermore, due to seven-day demand features, funding agreements can offer more liquidity in volatile market conditions than some traditional money market investments. Risks Even though investor demand for funding agreements has increased, many portfolio managers still oppose their use in money market funds. One of the most common arguments against funding agreements is that they should be considered "illiquid" securities. Because of the absence of a secondary market, accompanied with minimal contract standardization, many parties believe that funding agreements have no liquidity. No secondary market exists for funding agreements because they are insurance contracts and, therefore, cannot be traded. In addition, some argue that the demand features in funding agreements will actually decrease portfolio liquidity if a large percentage of the outstanding contracts is "put" back to the insurer over a short period of time and the insurer has difficulty fulfilling these large contractual obligations. Funding Agreements: Rewards vs. Risks Rewards:
Risks:
Another concern of portfolio managers is the lack of clarity and continuity in state insurance regulations regarding the claims priority of funding agreements in the event of issuer insolvency. According to some state insurance laws, funding agreements are treated as obligations of the insurance company, giving the contracts senior claims status over all creditors and making them pari passu with all policyholders. However, some states have not clarified the claims status of funding agreements, which creates uncertainty as to how these agreements would be treated in the event of an insurance company's liquidation. Because of the default in 1991 of two large insurance companies, Executive Life Insurance Co. and Mutual Benefit Life Insurance Co., some portfolio managers are worried about the claims priority of funding agreements. In the case of Mutual Benefit, GIC investors did not suffer any loss of principal, while Executive Life GIC investors experienced minor losses of both principal and interest. More importantly, both groups of investors incurred a long delay in the return of their principal. In both cases, the state insurance regulators treated GICs as pari passu with all other policyholders. As mentioned earlier, funding agreement investors are exposed to the inherent credit and liquidity risks of an insurance company. Therefore, a portfolio manager needs to thoroughly analyze the investment operations and financial strength of the funding agreement issuer. The portfolio manager should consider the asset/liability management techniques, capital position, investment policies, lines of business, and liquidity of an insurance company when determining the adequacy of its investment operations. When measuring the financial stability of an insurer, a portfolio manager can utilize the financial strength and claims-paying ability ratings provided by Fitch IBCA and other Nationally Recognized Statistical Rating Organizations (NRSROs). Rule 2a-7 Suitability A funding agreement must meet several criteria to be classified as an "eligible security" under Rule 2a-7 of the Investment Company Act of 1940 (the 1940 Act). First, it must be a "security" as defined by the 1940 Act. Second, it must have a remaining maturity of no greater than 397 days. Third, it must satisfy certain credit quality criteria, including, in most cases, bearing a rating in one of the two highest short-term rating categories from at least two NRSROs. Neither the SEC nor the courts have provided any guidance as to whether funding agreements are eligible securities. However, insurers offering these agreements, fortified, in some cases, by legal opinions issued by their counsel, have represented that such agreements meet the three criteria for an eligible security. First, based on certain features of such agreements and various authorities relating to other types of financial instruments, these insurers have persuasively argued that such agreements meet the first test of an eligible security, namely that it is a security within the meaning of the 1940 Act. Second, funding agreements targeted to money market fund investors typically meet the "remaining maturity" criteria for an eligible security by including demand features allowing the investor to put the agreement back to the insurer after the lapse of predetermined periods, each less than or equal to 397 days. Money market funds often invest in funding agreements with seven-day demand features. The variable rate of interest provided for in such agreements, coupled with the demand feature, allows the investor to treat the maturity of the funding agreement as the earlier of the period remaining until the next interest rate reset date or the date on which the holder, by exercising its demand right, can sell the security for its approximate amortized cost. This feature allows the fund to ascribe a seven-day maturity to such agreements in its determination of the fund's overall portfolio maturity under Rule 2a-7. Finally, a majority of insurance companies offering funding agreements have satisfied the credit quality criteria for an eligible security by obtaining a rating in one of the two highest short-term rating categories from at least two NRSROs. Fund managers should note that funding agreements that do not have seven-day demand features may be classified as illiquid securities for regulatory purposes and/or the fund's internal investment restrictions. Rating Agency Perspective As with any money market investment, funding agreements must meet a strict set of criteria before being eligible for purchase in a Fitch IBCA-rated money market fund. First, all eligible variable-rate securities (i.e. funding agreements) should support a stable portfolio net asset value (NAV) by providing a market value that approximates par at the security's interest rate reset date. Moreover, the interest rate index that is chosen must be one that moves in tandem with short-term market rates, i.e. one-month LIBOR and Fed funds. Long-term interest rate indexes, such as the 10-year CMT, and indexes that lag market rates, such as the 11th District Cost of Funds Index, are not appropriate for money market funds. Also, Fitch IBCA will not permit investment in variable-rate securities with complex coupon formulas similar to those found in some structured notes. In addition, since most funding agreements have demand features, it is important to evaluate the quality and liquidity of the feature. Fitch IBCA's Managed Funds group looks to the rating of the issuer when determining the issuer's ability and willingness to honor the demand feature, especially during periods of stress. When assigning a claims-paying ability rating for an insurance company, Fitch IBCA factors in the ability and willingness to honor all obligations, including funding agreements with their associated demand features. Second, the credit quality of the issuer, as well as the level of concentration with any single issuer, is also measured. Also, for all funding agreements that have demand features beyond seven days, Fitch IBCA will regard the put date, not the interest rate reset date, as the final maturity for the investment. Finally, Fitch IBCA defines any funding agreement that does not have a seven-day demand feature as an illiquid security, and such illiquid securities cannot comprise more than 10% of total money market fund assets. Funding agreements are viable investment alternatives for money market funds if they are structured properly and entered into with creditworthy issuers. Through demand features, money market funds are able to obtain the liquidity they need to maintain a stable NAV. Furthermore, by performing a thorough company/investment analysis and utilizing NRSRO ratings, an investor can make an accurate assessment of the financial strength and claims-paying ability of an issuer.
Read Next: Social Security: Getting at the Issues of Underfunding & Options for Reform
|
|
