While the likelihood of negative interest rates for sterling remains low, treasurers should be aware of the impact such a development would have on UK money market funds, say Invesco’s Natalie Cross and Paul Mueller.

Negative interest rates are not a new concept, having been previously introduced by the European Central Bank (ECB) in 2014. But could the UK adopt negative interest rates for sterling in the wake of the COVID-19 crisis? And what would this mean for UK money market funds?

Live policy option

At this stage, negative sterling rates continue to be a more remote possibility. “Our central case remains that we don’t expect negative rates,” comments Paul Mueller, Senior Portfolio Manager at Invesco. “But seeing as the UK economy is being hit with a once-in-a-generation impact, not just with COVID-19 but also with Brexit, I think it’s certainly a non-negligible risk.”

Since the Bank of England cut rates to 10 basis points earlier this year, the focus of subsequent actions has been on increasing quantitative easing, says Mueller. “So that seems to be the preferred option at present – but we may get to the point where there could be operational issues, for example, the bank won’t want to distort the free float of gilts in the market.”

And with the Bank of England carrying out a full review of the possible impact of negative rates on banks, Mueller says it is clear this is a “live policy option”, in a way that it hasn’t been in the past. And while recent vaccine announcements have brought positive news, plenty of uncertainty remains where 2021 is concerned.

Implications for yield

For money market funds, the major question is what negative rates would mean for yield. As Natalie Cross, Senior Client Portfolio Manager at Invesco notes, money market funds are highly liquid, meaning that any changes in bank rates tend to filter through reasonably quickly – particularly at present, with funds holding more liquidity due to the uncertainty brought by the pandemic.

In the event of negative rates, Cross says the gross yield of funds would “certainly go down” – although she adds that most MMF providers are committed to waiving management fees in order to try to continue offering a positive yield. “Obviously it would depend on the level of the rate cut, the market reaction and the resulting impact on reinvestment levels,” she says.

Cross also points out that under current regulations, fund providers are not permitted to support money market funds – “so once the gross yield of a fund falls into negative territory, there’s nothing a fund provider can do to prop that fund up and keep it at zero or positive yielding return.”

In the meantime, Mueller notes that some issuers, especially at the front end of the curve, are already offering negative yields. “Yields are not just a function of rates, but also of credit spreads, and supply and demand,” he says. “So if there is an excess of demand versus supply of paper, that could also put downward pressure on yields, even without any movement in interest rates.”

Other impacts

Aside from yield, another consideration is that a negative yielding environment would affect the share classes that money market funds are able to offer. “As a result of the recent reform, negative yielding money market funds are no longer allowed to offer distribution share classes,” Cross explains. “For those funds, clients would only have the option of accumulation classes. These operate slightly differently from distribution classes, while still very much remaining part of the same fund, with identical fee levels.”

The key differences between the two are that accumulation classes do not transact at a price of 1.00, or distribute income on a monthly basis. “Instead, they roll the income into the price of the share class on a daily basis,” says Cross. “So that’s quite a significant impact in terms of how the product operates.”

Ready or not?

Given the significance that negative rates would have for money market funds, what should corporate treasurers be doing now to prepare for this possibility?

For one thing, says Cross, treasurers should communicate with their money market fund providers to understand what the process will be if yields turn negative – “Will they move investors into new share classes? Will they convert existing share classes across to an accumulation version? Will clients need to submit an instruction in order for them to do that?”

Treasurers should also consider whether their existing treasury management strategy covers the possibility of negative yields – and if not, they should update their strategies as soon as possible, not least because negative rates would also likely affect bank deposits and other short-term investments. Similarly, treasurers should ensure that their treasury management systems can handle negative yields.

Of course, investors who held euro deposits or money market funds in 2014 will already have gone through this process. But Cross points out that things may be different this time. “For some banks, there was a waterfall effect, with investors that were holding larger balances seeing negative yields sooner than investors with smaller balances,” she says. “But now banks are much more prepared – so if rates do go negative on the sterling side, it will be a lot easier for them to switch over immediately, meaning there may not be the same staggered effect.”