As yields dwindle, 'cash' fund investors take on more risk

NEW YORK, April 4 Thu Apr 4, 2013 3:17pm EDT

NEW YORK, April 4 (Reuters) - A hunt for higher yields by risk averse investors is helping spark a resurgence in funds that can invest more broadly and take bigger risks than strictly regulated money market funds.

The growth in these so-called cash funds, however, is worrying for some who see it as another symptom that the Federal Reserve's ultra loose monetary policy is bringing on another broad credit boom that could end badly for borrowers, lenders and investors.

Strict investing regulations that govern the $2.6 trillion money fund industry have caused annual returns in that sector to dwindle to only 0.04 percent, on average.

This is creating new demand for alternative funds which can reach out to longer-dated maturities and lower-rated credits to generate higher returns. These funds are still positioned as a low risk investment that is managed conservatively with the assumption of the full return of the investment.

Assets in these funds that have average weighted maturities up to a year, excluding exchange-traded funds, have grown to $48 billion as of February 2013, from $36.4 billion at the end of 2011, according to data by Lipper. At the end of 2008 there was just $12.1 billion in the funds.

BlackRock, Oppenheimer, Pioneer, Fidelity and Putnam are among those that have launched such funds in the past two years.

The funds are not invested in highly complicated and structured mortgage-backed investments, like in 2007-2008, though they are starting to buy higher quality mortgage-backed securities.

To many, the reach for yield by conservative investors is a sign of desperation for returns after four years of rock-bottom rates and no indication that the Fed plans to scale back the central bank's ultra-low interest rate policy.

"In general, we're doing the entire credit boom all over again," said Brian Reynolds, chief market strategist at Rosenblatt Securities in New York.

Money funds have seen some of the biggest reforms since the crisis. New rules are designed to reduce their systemic threat after an investor run led some of their share prices to "break the buck," that is, fall below a $1 net asset value, a watershed that intensified the credit crisis.

But, "if you push one part of it in, another part expands somewhere else," Reynolds said. "Anecdotally, we can see that the enhanced cash, or the cash plus, that lie somewhere on the spectrum between true bond funds and true money market funds are taking more risk to get more yield."

To get higher yields many are reaching into investment grade corporate debt, residential and commercial mortgage-backed securities and other credit instruments that return more than U.S. government debt.

Annual returns in the category vary widely from 0.10 percent or less to more than 4 percent, though most currently sit between around 0.50 percent and 1.50 percent.

CHECKERED HISTORY

The sector has a checkered past. Funds sold as "enhanced cash," or "cash plus," came under scrutiny after a series of high-profile failures in 2007-2008 after investing in risky mortgage-backed debt that led to dramatic redemptions and caused large investor losses.

This time around, fewer of the new funds have adopted the term "cash" in their names and marketing. Some were mired in legal disputes on allegations they were sold as money market equivalents, when they actually took much higher risks and did not guarantee the return of their principal.

Most are also not yet reaching into low junk-rated assets. But some worry that cash investors expecting highly liquid investments and low market volatility may not fully realize how illiquid some of the debt can be.

"I believe that investors perceive these funds as going to have liquidity which is not consistent with the underlying securities during a time of stress," said John Spengler, senior portfolio manager at Clearwater Advisors, an investment advisor based in Boise, Idaho.

Growth in these funds may also be helping feed a revival of securitized debt, which is less liquid during times of market stress.

Record investment in money market funds was a factor behind the dramatic growth in highly complex and structured vehicles created by banks to satisfy demand before the crisis, which later turned sour. Those banks encouraged borrowers to take on inappropriate home loans that they were later unable to repay.

"The history of mutual funds is the story of demand creating its own supply," said Peter Crane, President of Crane Data, which analyses money fund investments.

Crane said the main risk is the possibility of an investor exodus on concerns about what the funds are exposed to, as happened in the crisis on concerns over asset-backed exposures at both regulated money funds and enhanced cash alternatives.

Many of the newer funds have not been tested in an environment of volatile or falling markets. Investors that hunt out higher yields for yields' sake may be among the most likely to run at the first sign of trouble, Crane said.

Enhanced-cash exchange-traded funds add a new element to the sector, as it is unknown whether trading on exchanges will add to or subtract from the risk of investor flight in a downturn. The largest is Pimco's Enhanced Short Maturity Exchange-Traded Fund, which it launched in 2009, and now has total assets of $2.77 billion.

Guggenheim Investments launched an Enhanced Short Duration Bond ETF in 2008; it has assets of $231,000.

Thus far, some managers say that investors have learnt lessons, noting that new funds are not investing in highly structured deals.

Yeng Butler, who heads cash management strategies at State Street, said that so far she has seen few clients shifting from money funds into enhanced cash strategies, but notes many are considering shifts depending on further money fund reform.

Of those seeking out higher yields, most have shown a preference to go longer in duration than down in credit quality. "Very few clients that we have spoken with are willing to make that tradeoff in terms of credit quality," she said.

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