NEW YORK, Dec 14 (LPC Reuters) - Under new rules from the US
Securities and Exchange Commission (SEC), investment firms will
be allowed to raise loan mutual funds but may be forced to
defend their decision to invest in products deemed less liquid
by the regulator.
In October the SEC voted to adopt rules to improve the
liquidity risk management of open-end mutual funds and
exchange-traded funds (ETFs), which are popular investments in
retirement savings accounts.
The regulator wants to ensure that funds can meet any
redemption requests. It has criticized long settlement times as
a potential liquidity risk and highlighted trades in the
US$870bn US leveraged loan market that take almost 20 days to
Going forward, the SEC can also ask managers to explain why
their investment strategy is appropriate for open-end funds,
which allow investors to redeem their money daily.
"There is no question the SEC is very focused on this
and is going to be looking when funds put their
liquidity plans together," said Elliot Ganz, general counsel at
the Loan Syndications and Trading Association (LSTA), adding
that managers need to be "very serious about how they manage
Under the rules, which are part of the SEC's effort to
enhance monitoring and oversight of the asset management
industry, firms will have to classify each investment into four
buckets based on the number of days it will take to convert to
cash without significantly changing the value.
The SEC lists loans as an example of a less liquid
investment, which it describes as an asset that can be sold in
seven days but takes longer to close than that time period,
which comes as a relief to the industry. There was concern that
loans could be classified as illiquid under the original 2015
SEC proposal, David Wang, an analyst at Moody's Investors
Service, said. Funds can only hold 15% of illiquid assets, which
could have made it difficult to raise new open-end loan funds.
"The very good news is that the Commission recognized that
loans are not illiquid - they trade in a way that is liquid and
the slower settlement times do not make them illiquid but pushes
them into a category that is less liquid - and that certainly
allows for the continued existence and issuance of loan mutual
funds," said Ganz.
Loan mutual funds and ETFs had US$126bn of assets under
management in November, according to Thomson Reuters LPC data.
Investors poured US$1.8bn into the funds in the week ending
December 7, in the largest inflow since August 2013, according
Inflows are expected to continue as loan funds are viewed as
a hedge against rising interest rates. Floating-rate loans pay
investors a set amount plus Libor, and interest payments
increase as rates rise. The Federal Reserve on Wednesday raised
rates by 25bp, the first increase in a year.
The SEC's ability to quiz managers about how investing in
less liquid loans is appropriate in funds with daily redemptions
is causing concern and could encourage some firms to pick
structures that lock up investor money for extended periods of
time, sources said.
"The SEC staff will likely say, justify this strategy and
explain to us on the record how the fund is going to comply with
its liquidity risk management obligations," said Kenneth Burdon,
counsel at law firm Skadden, Arps, Slate, Meagher & Flom.
The SEC was previously able to ask for additional
information after firms filed a registration statement for a new
open-end mutual fund, but this may be the first time that the
regulator has put this option in writing.
"Essentially the SEC is using what I think of as its bully
pulpit to urge fund management and boards to think harder about
whether holding securities with longer settlement periods is
appropriate with this type of fund," said Nathan Greene, co-head
of the asset management group at law firm Shearman & Sterling.
Open-end funds need to meet redemption requests in seven
days. It took 19.1 days on average to close a loan trade in the
third quarter, according to IHS Markit. High-yield bond trades
close in three days.
The gap between the time it takes to settle a loan trade and
the time a fund has to meet redemptions still remains, which
creates a possible scenario where firms may struggle to complete
loan sales fast enough to meet withdrawal requests.
One way of addressing this mismatch is with an investment
fund that has quarterly or bi-annual redemptions, said Steve Tu,
a Moody's analyst.
The new rule may encourage advisers and fund boards, which
ultimately have to approve new investment products, to consider
whether a closed-end structure is more appropriate for a loan
fund, Burdon said.
An SEC spokesperson declined to comment.
(Reporting by Kristen Haunss; Editing by Michelle Sierra and