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The
SEC
issued two important proposals in late
2015
,
the first of which was released in September and
designed to “enhance effective liquidity risk manage-
ment” for mutual funds and exchange-traded funds.
Among other things, the proposed regulations would
shine a light on the liquidity characteristics of fund
holdings, while also mandating that a portion of each
portfolio be easily liquidated within three days
without triggering big price losses.
The second proposal was released a couple of months
later and meant to “enhance the regulation of the use
of derivatives” in funds. This proposal would require
compliance with one of two rules designed to limit the
amount of leverage that funds can develop with deriv-
atives. The first rule would cap a fund’s exposure to
certain kinds of transactions (including derivatives) at
150%
of net assets. The second would allow exposure
up to
300%
but would require the use of a so-called
value-at-risk test to ensure funds were taking on less
market risk than if they hadn’t used derivatives at all.
A Surprising Feature of Derivatives
The
SEC
’s motivation is sound. There is too much
opacity in mutual funds in terms of both liquidity
and derivatives exposure. But, while the first proposal
is designed to ensure portfolios maintain plenty
of liquidity, the second has the potential to discourage
fund managers from using tools that can help
in that effort. That’s because for all of the negative
connotations associated with derivatives, they can
often be much more liquid than bonds themselves.
Take credit default swaps, for example. In recent
trading for those linked to the U.S. corporate-bond
market, the volume of credit default swaps traded
regularly exceeded the volume of all U.S. corporate
bonds. In part, that’s because derivatives are more
popular with many investors who don’t have to find
actual bonds to buy or sell—a difficult and time-
consuming task, especially amid times of scarcity
among particular names. Moreover, using derivative
contracts typically requires investors to come
up with much less cash than would be necessary
to purchase bonds.
Ironically, it was the financial crisis itself that high-
lighted the better liquidity characteristics of many
derivatives, including credit default swaps. As the
crisis threatened the banks at the foundation of
the capital markets, bond trading became extremely
difficult and in some cases froze entirely. Outside
of the super-high-quality and liquid U.S. Treasury
market, most bond prices plummeted. Derivatives
tracking those bonds or their markets sold off, too, but
because they could be much more easily traded,
many of them maintained higher valuations than the
bonds to which they were linked.
Definitely Worthy of SEC Attention
There are excellent reasons for the
SEC
to take on
these issues. Most observers in the industry agree
that banking regulations implemented since the
2008
financial crisis have inadvertently hurt liquidity
in the bond market. And though high-profile liquidity
troubles among mutual funds are extremely rare, it
makes perfect sense to provide a framework for fund
companies to manage portfolio liquidity and provide
information that investors can use to evaluate risks in
their portfolios.
Derivatives are valuable and important portfolio tools,
but their use and disclosure deserve a lot more
scrutiny. As the
SEC
’s proposal notes, there have been
very few limits on gaining leverage with derivatives,
or effective rules for disclosing those exposures to
help investors.
Both proposals are first drafts, and, if implemented,
the final versions could look quite different. But
if the end result is that new rules make it significantly
more difficult for funds to use derivatives in ways
that improve liquidity, it would be an unfortunate
consequence of well-meaning efforts.
K
Contact Eric Jacobson at
eric.jacobson@morningstar.comThe New Bond-Fund Rules
Income Strategist
|
Eric Jacobson