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1390SEC Warns of Fixed Income Fund Risk

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  • Baker, John
    Jan 16, 2014
      In another example of regulatory concerns that fixed income investments may be stressed by interest rate increases, the Securities and Exchange Commission's Division of Investment Management has issued guidance to fund advisers and boards on Risk Management in Changing Fixed Income Market Conditions. IM Guidance Update 2014-1 (Jan. 2014). The guidance warns of the importance of sound risk management and disclosure practices by fixed income mutual funds and exchange-traded funds, particularly as the Federal Reserve Board contemplates the possible end of both quantitative easing and the period of near zero interest rates that has persisted for the last five years. The staff guidance follows on the heels of other warnings from the SEC staff and FINRA of the risks to interest rate sensitive securities if interest rates rise.

      The IM Guidance Update notes that bond mutual funds and ETFs experienced net outflows of about 1.8% of aggregate assets in June 2013, when the 10-year Treasury note yield rose by almost 50 basis points, and that in both 1994 and 2000 rising interest rates led to several months with bond mutual fund outflows of 1 - 2% of aggregate assets. However, in 1994 and 2000 the market for bond funds was much smaller and dealer inventories of corporate bonds were proportionately much greater. The size of dealer inventories is a proxy for their appetite and capacity to make markets by committing their own capital, as principal, to intermediate for time and size differences in demand between buyers and sellers in the fixed income market. A significant reduction in dealer market-making capacity has the potential to decrease liquidity and increase volatility in the fixed income markets.

      The IM Guidance Update recommends several steps that fixed income fund advisers may consider taking, and it also notes that fund boards may want to consider discussing with fund advisers the steps these advisers are taking in this area:

      *Assess fund liquidity needs during both normal and stressed environments
      *Assess the impact (beyond just liquidity) of various stress tests or other scenarios on funds
      *Evaluate what risk management strategies and actions are most appropriate in response to changing fixed income market conditions
      *Consider what information should be provided to fund directors
      *Assess the adequacy of disclosures to shareholders and the appropriate manner of communicating risks to shareholders

      The SEC's Office of Compliance Inspections and Examinations also noted, in its Examination Priorities for 2014, that the staff will monitor the risks associated with a changing interest rate environment and the impact this may have on bond funds and related disclosures of risks to investors. (Other priorities that were not mentioned in the Examination Priorities for 2013 included advisers with substantial reliance on quantitative trading models and whether securities lending arrangements comply with exemptive orders and relevant no-action letters.) Similarly, FINRA stated in its 2014 Regulatory and Examination Priorities Letter that FINRA examiners will especially focus on accounts with concentrations in interest rate sensitive securities, such as long duration bond funds and bond ETFs, and the disclosures or omissions of material facts when these products are recommended.

      IM Guidance Update 2014-1 is available online at


      For OCIE's Examination Priorities for 2014, see


      FINRA's Regulatory and Examination Priorities Letter is linked at


      John M. Baker, Esquire
      Stradley Ronon Stevens & Young, LLP
      1250 Connecticut Avenue, N.W., Suite 500
      Washington, DC 20036-2652
      p: 202.419.8413
      f: 202.822.0140
      FundLaw Listowner http://groups.yahoo.com/neo/groups/fundlaw/conversations/messages