(Bloomberg) -- Banks and other companies that have witnessed borrowing costs shoot up in the past year are about to feel more pressure in a $1 trillion market for short-term IOUs.
Investors are poised to pull as much as $400 billion from U.S. money market funds that buy commercial paper, predicts JMorgan Chase. The looming exodus, a consequence of steps to make money markets safer after the financial crisis, is set to accelerate before October. That's when SEC rules take effect mandating that so-called institutional prime funds, among the main buyers of commercial paper, report prices that fluctuate. Traditionally, those funds have stuck to $1 per share.
Wall Street strategists say investors may already be shifting from prime funds to those focused on government debt, which will keep a fixed share price.
The diminished appetite for commercial paper is a potential headache for banks and other issuers, which saw the cost of the IOUs climb to an almost four-year high in recent weeks. The companies use the instruments for everything from loans to payrolls.
Commercial-paper "issuers will either have to find other investors to fill in the gap, or may have to raise the rate they are offering to get additional interest," said Gregory Fayvilevich, an analyst in the fund and asset management group at Fitch Ratings in New York.
The move by investors is the next big wave of cash to leave prime funds because of the new rules. It would come on top of about $250 billion of assets that U.S. money fund companies have already converted over the last year from prime funds to those that only hold government securities like Treasury bills. The SEC measures will force institutional prime funds to tell clients daily whether their investments gained or lost value.
The money market industry's changing landscape has already lifted companies' short-term borrowing costs: Rates on six-month commercial paper reached the highest above Treasury bills since 2012 this year as demand waned relative to government debt.
Financial firms' short-term debts, including commercial paper, certificates of deposit and time deposits, make up U.S. prime funds' biggest holdings. Bank of Tokyo-Mitsubishi, Credit Agricole, Sumitomo Mitsui Bank, Royal Bank of Canada and DNB Bank comprise the top five issuers of this debt held by the funds, according to Crane Data.
Longer maturities and more diversification are part of the answer at Credit Agricole CIB, said Oskar Rogg, head of Treasury for the Americas in New York.
Mitsubishi UFJ has also diversified the way it raises funds, including by acquiring foreign-currency deposits, according to its spokesman Kazunobu Takahara. Sumitomo Mitsui plans to keep commercial paper as an option and aims to prioritize foreign-currency financing, said Takafumi Sasaki, a Tokyo-based spokesman. Sandra Nunes at Toronto-based RBC and Even Westerveld at Oslo-based DNB declined to comment.
Issuers have other options as money-fund demand for commercial paper dwindles, including the market for repurchase agreements, where they borrow cash temporarily using securities as collateral, according to Joseph Abate, a money-market strategist at Barclays in New York.
Banks are finding it more expensive to borrow across all maturities. Their average borrowing costs on longer-term debt are near the highest in more than two years, according to Bank of America Merrill Lynch indexes. Slowing economic growth is fostering concern that global central banks will keep interest rates low, crimping financial firms' profits.
With fund companies converting or closing prime offerings, the industry's holdings of government securities have swelled. Taxable money-funds' investments in government obligations rose to $1.47 trillion as of the end of January, from $1.18 billion in February 2015, according to Crane.
Estimates vary for the size of the next wave, when investors yank cash from prime funds. JPMorgan projects it will reach about $400 billion this year, while Barclays anticipates about $300 billion.
Peter Crane, president of the Westborough, Mass.-based firm that tracks the industry, expects that only about $250 billion will leave prime funds, because he predicts investors will still favor the higher rates on those products and given his expectation that net asset values of prime funds will remain stable. Institutional prime funds' seven-day yield was 0.21% as of Jan. 31, compared with 0.1% for government funds, Crane data show.
Even at the lower amount that Crane predicts, the flow of funds may push up borrowing costs on commercial paper relative to Treasury bill rates, which have crept up from near zero after the Federal Reserve's December liftoff.
"Government securities will be in high demand, depressing the yields there, and the demand for credit instruments will be smaller," said Peter Yi, Chicago-based director of short-term fixed income at Northern Trust, which manages $875 billion. "As that happens, we're forecasting spreads between commercial paper rates and government securities to widen."
The commercial paper market may shrivel by an additional 15%, according to Abate at Barclays. "The market is going to contract and yields are going to get higher," he said.