2012 Financial Markets Conference
April 2012
An interview with Karen Dunn Kelley, senior managing director and chief executive officer, Invesco Fixed Income for Invesco Limited
Paula Tkac: With me today is Karen Dunn Kelley, senior managing director investments at Invesco. So Karen, you participated in our Financial Markets Conference on a panel about money funds. Can you tell me briefly how you see the role of money funds in the financial system and sort of the broader economy. Where do they fit in?
Karen Dunn Kelley: Let me say two things, and I'll answer this two ways. It is that there are 95 million money market accounts in this country, so people and institutions want to buy money market funds. So the role in the economy is both from financing the economic and the economy and the banking and corporate sector of the U.S., but it is also facilitating the needs of the investors. So with $2.7 trillion in assets under management in the money market industry you see that it's really very important because of those products. You have about 55 percent of them in prime funds, about 34 in government funds, and about the balance is in the tax-free environment. So it's all three of those assets classes. And investors are both institutional and retail, so it really does serve the broad needs of the population in terms of a vehicle to invest.
On the other side, as we look at it on a taxable basis it actually finances about 21 percent of the taxable fixed income short-term markets. And if you look at it as probably the highest at about 37 percent in the commercial paper market and in the euro, CD market, banking market, it's probably about 14 percent. So that gives you a concept. On the tax-free side, however, it is much larger where it actually finances about two-thirds of all the short-term municipal paper issued in this country.
Tkac: So the role of the money funds in terms of systemic risk really typically relates to the possibility of runs and the subsequent contraction of credit if there are stresses in the money fund industry. So is this what happened in 2008? I mean, were the large flows out of prime funds primarily what you would call runs or were there other factors at play in that, sort of, market episode?
Dunn Kelley: That market episode, Paula, there was so much going on and as you were getting through the summer and into the fall, I mean, really, the entire global credit markets were coming to a halt. And really, when you think about it, and you start with Fannie and Freddie and AIG and Wachovia Bank, and then what was the Fed's policy going to be, and the uncertainty of what was going to happen in the marketplace, it was an absolute myriad of different events all culminating, and I think, really, the tipping point was when Lehman declared bankruptcy, and at that point things then started to move very, very quickly. And, just as an aside, I think that the Federal Reserve, SEC, and the other regulatory groups did a tremendous job in stabilizing those markets during those times. Was everything absolutely perfect, and would I have made every same decision? No. But, the overall effect was that they did create calm in the global markets.
Tkac: So returning to this, sort of, potential for a systemic risk issue, it seems to me that incentives, actually, are pretty well aligned. The public and regulators don't want a run and a systemic event. It doesn't seem to me the fund sponsors probably want runs and systemic events, right...
Dunn Kelley: Yes, I promise you.
Tkac: ...So I guess one of my questions is, can you tell me a little bit about Invesco's philosophy and processes for managing these money funds? How do you think about your fiduciary duties and the other things that you have mentioned with respect to how you manage these particular asset classes?
Dunn Kelley: So a couple of comments to make. Invesco has been in the money fund business since the early '80s. Rule 2a-7, which is the regulation that defines money market funds, was not promulgated until 1982. So we have really been in the money fund business since its inception, and through all the amendments through the '80s, '90s, 2000s, up to the latest one in 2010. But since the beginning, we have had philosophical tenets of safety, liquidity, and yield. And, really, safety is the simple principle of "I want my dollar back, when I want my dollar back I want it to be safe." OK. And that safety really comes from portfolio holdings, portfolio structure, and the operational risk you take.
The second fundamental tenet is liquidity. And liquidity is that movement of cash at the need and the time that the either institutional or individual wants it. Liquidity is one of those things that was said years ago, "Lliquidity is like water, you don't know how important it is until you don't have it."
And then finally yield. And yield is nothing more than a byproduct of safety and liquidity, which is why money funds have lived in 10, 12 percent interest rate environments, and now down to where 67 percent of them have less than 10 basis point interest rates on them.
Tkac: So today we heard a little bit about concerns, potentially, for credit risk in some money funds, and I know you've talked a lot about the 2a-7 regulations and how that helps to limit those things. But, again, in the grander scheme of things, do you ever worry as a market participant with a big money fund business about a rogue fund out there that might take a credit risk, might break the buck, and precipitate a larger problem? And how does the industry see that problem of managing its own?
Dunn Kelley: We take that very, very seriously, and there is an industry group called the ICI, Investment Company Institute, and we really sit down and we spend an awful lot time on that subject. And I would suggest to you, and I'm not saying this in an absolute, 100 percent parallel path, but one of the things that we did in the 2010 rules and the SEC, when we worked with and gave guidance and gave a white paper on what we thought of the rules. It was really to bring those whole standards up to the very best as opposed to the lower. So we lowered weighted-average maturity, we lowered weighted-average life, and therefore credit went up and the whole portfolio structure was helped. But, yes, that is an issue; we can't deny that that's an issue.
Tkac: But there is a lot self-monitoring, it sounds like.
Dunn Kelley: Self-monitoring. And by the way, part of the new rules is all about transparency. So every portfolio gets put on a website, which is publicly available so everybody knows what everybody holds...
Tkac: Everybody is holding.
Dunn Kelley: ...Yeah. So there is that kind of thing because you are showing your classroom test paper to everybody in the world.
Tkac: So one of the questions that faces regulators as they do try to understand whether or not there need to be additional reforms is, "What would investor response be to some of the proposals to change money funds?" So we'll have a proposal to maybe move from fixed to floating NAV [net asset value] or maybe a capital requirement, which would change the structure. What do you...a little bit about who your investors are, but what do they tell you about what they are looking for in a product and the extent to which there are substitutes out there, right now, that seem attractive to them, or where they might go if, for whatever reason, the money funds change dramatically.
Dunn Kelley: Let's take them in sort of those three steps. And again, we very much view ourselves as fiduciary so we are acting on the execution of these investment vehicles, these products for our client base, and what they have asked us for is that "three philosophical tenets of safety." And when we think about further reforms and we think about what happens, and one of the things that's always being discussed from constant NAV to floating NAV. That would be an absolute game-changer, because, Paula, remember under the tax laws every time then you would be buying and selling you would be doing it at a different dollar value, and so the tax consequences would become enormous, and it would just become an unruly thing to be able to monitor what those fluctuations were at what day and how many events you have...
Tkac: Especially for an institutional client, I would imagine.
Dunn Kelley: ...Oh, especially for a big institutional client. But, again, even if you are a retail investor you don't want to hire three accountants to figure out what your value of your money fund is on a daily basis because you wrote a couple checks on it or something. Right? So it goes across.
The other thing they talk about is capital and the capital requirement. Well, there are certain issues that you get when you get into the discussion about capital and is the capital enough—what is the right amount of capital? And if there is capital, does that create some kind of a moral hazard because then you say, "Oh, there's capital, I can take greater risk." So what we really think is that one of the things you want to do is align, as you said, the regulator, the sponsor, and the investor's interest in the same thing.
Tkac: Following up on that, as we said, there have been these proposed further reforms and people have talked, typically, a lot about the changes in liquidity and maturity that were put in place in 2010. But tell me a little bit about the changes in governance because I think this is one place that sometimes gets overlooked and it relates to, I think, aligning of incentives.
Dunn Kelley: Yes, that's exactly right. The governance one is one of the ones that I think is absolutely the most important because what it did is it mandated a preordained orderly liquidation. And that has been creating greater governance from the independent board of directors on the money market funds to actually institute that liquidity. So there is no money fund that is too big to fail. And the other part of that that I would want to make comment on is that once that liquidation happens, it is permanent. It can happen because of credit, it can happen because of liquidity, but once it happens it is not reversible. And so that is really one of the most important things that the industry and the SEC mandated with its 2010 rules.
Tkac: So specifically this would mean that if there were losses in asset value and a fund were to break the buck, there could be an immediate cessation of activity, liquidation of the fund, and if it's worth, say 97 cents, or 95 cents, then immediately things would stop and investors would know that they had their 95 cents.
Dunn Kelley: That's exactly right. It would be an orderly liquidation out of the product and it would halt so that would be the end of activity. So, that's right.
Tkac: Great, thank you.
Dunn Kelley: Thank you.