Regulatory Guidance Regarding Changes in Fixed Income Market Conditions

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1 Regulatory Guidance Regarding Changes in Fixed Income Market Conditions John V. O Hanlon Joshua Katz Dechert LLP Mutual Fund Directors Forum 2014 Policy Conference April 2-3, 2014 John V. O'Hanlon is a partner and Joshua Katz is an associate in the Financial Services Group of Dechert LLP.

2 The Securities and Exchange Commission ( SEC ) and the Financial Industry Regulatory Authority ( FINRA ) recently issued guidance addressing risks raised by changes in the market environment for fixed income investments. Specifically, the SEC s Division of Investment Management ( IM Division ) published guidance suggesting measures that fund advisers should consider in light of recent changes in the markets for fixed income securities. In addition, FINRA has highlighted risk disclosure relating to certain types of fixed income investments as an examination priority. This memorandum provides an overview of the regulatory guidance and discusses considerations for fund boards in light of the guidance. I. IM Guidance Update: Risk Management in Changing Fixed Income Market Conditions In January 2014, the IM Division released IM Guidance Update No , entitled Risk Management in Changing Fixed Income Market Conditions (the Guidance Update ). The Guidance Update examines current fixed income market conditions and makes several suggestions to fund advisers regarding risk management and disclosure matters. In addition, the Guidance Update notes that fund advisers may wish to provide fund boards with information concerning the issues raised in the Guidance Update to help facilitate board oversight functions. Fixed Income Market Conditions The Guidance Update notes that the fixed income markets have experienced consistent growth over the past three decades. Much of this growth has occurred recently, as interest rates have been at or near historic lows for the past five years. In June of 2013, the fixed income markets began experiencing increased volatility in response to rising interest rates and the prospect of the Federal Reserve Board tapering its quantitative easing program. The Guidance Update notes that the 10-year Treasury note yield rose by almost 50 basis points in June 2013, and fixed income funds and exchange traded funds ( ETFs ) experienced almost $70 billion in net outflows. The Guidance Update states that although the fixed income markets are generally expected to underperform during periods of rising interest rates, the recent outflows are occurring in a unique environment, which may subject investors to heightened risks. Prior periods of rising interest rates and corresponding declines in bond values occurred when the overall fixed income market was much smaller. Further, dealer inventories of fixed income securities, which facilitate dealers market making capability, comprised a much larger share of the market at that time. Current conditions are far different as dealer inventories have remained relatively stagnant when compared to market growth. If broader structural changes (e.g., reductions in proprietary trading desks, increased regulatory capital requirements, etc.) explain the apparent reduction in dealer market making capacity, then fixed income funds and ETFs could be subject to increased volatility and liquidity risk for the foreseeable future. The fact that the Federal Reserve Board has started tapering its quantitative easing program may contribute to this concern. 2

3 Risk Management and Disclosure Recommendations In response to the risks described above, the Guidance Update makes the following recommendations: Assess and Stress Test Liquidity The Guidance Update recommends that fund advisers assess their liquidity needs in both normal and stressed environments, and also consider their sources of liquidity (i.e., whether sources would require selling assets in declining or dislocated markets). Conduct More General Stress Tests / Scenario Analyses The Guidance Update recommends that fund advisers consider other factors in stress test scenarios (e.g., interest rate hikes, widening spreads, price shocks, increased volatility, etc.). Risk Management Evaluation The Guidance Update recommends that fund advisers evaluate different risk management strategies in light of possible changes to fixed income market conditions (e.g., decisions regarding composition, concentration, diversification, liquidity, etc.). Communication with Fund Boards The Guidance Update recommends that fund advisers adequately inform their boards of possible risk exposures due to the concerns raised. Shareholder Communications The Guidance Update recommends that fund advisers re-evaluate the adequacy of their shareholder risk disclosures in light of the concerns raised. II. FINRA 2014 Examination Priorities On January 2, 2014, FINRA published its 2014 regulatory and examination priorities (the Priorities ). FINRA publishes its priorities each year in order to highlight significant risks and issues that could adversely affect investors and market integrity in the coming year. In the Priorities, FINRA states that it remains concerned about the suitability of recommendations to retail investors for complex products whose risk-return profiles, including their sensitivity to interest rate changes, underlying product or index volatility, fee structures or complexity may be challenging for investors to understand. FINRA notes that in some cases, the challenge of understanding products may be exacerbated by ineffective disclosure practices. Therefore, FINRA intends to focus its examinations on the manner in which firms disclose material risks to investors and the policies and procedures surrounding those disclosures. As with the IM Guidance, FINRA s concern with fixed income investments focuses on the volatility of the interest rate environment. FINRA notes that in the current environment, there are potential downside risks to interest rate sensitive fixed income products that could arise from an unanticipated, rapid or uncontrolled shift in the interest rate environment precipitated by changes in monetary policy. In light of the suitability concerns raised by these risks, FINRA 3

4 examiners will focus on concentrations in longer duration instruments, including bond funds with longer average durations, and high yield securities recommended to retail investors, especially if those investors have near-term liquidity needs or have a conservative or defensive investment profile. FINRA examinations will include a review of the training provided to retail investor-facing brokers. FINRA will seek to determine whether these brokers fully understand the specific risks of the products they recommend. The Priorities also highlighted a number of products that FINRA believes present heightened investor protection concerns, including certain interest rate sensitive securities: Mortgage-Backed Securities. Rising interest rates may extend average life of loans within the securitized pool, putting downward pressure on the price of these securities and harming investors with shorter term liquidity needs, or those investors who are unable to hold the securities until maturity. Long Duration Bond Funds. Rising interest rates may lead to fund outflows, forcing managers to sell bonds at disadvantageous rates. Also, the possible lack of bid for relatively long duration bonds could force managers to sell lower duration bonds, thereby increasing weighted average duration and putting further downward pressure on price. Long Duration Bond ETFs. Pressures are the same as for Long Duration Bond Funds; however they could occur at a greater velocity. It is unclear what role Authorized Participants will play if there arises a bid/ask imbalance or a misaligned net asset value. Long Duration Corporate Bonds (particularly zero coupon or bullet bonds). Long duration corporate bonds are vulnerable to losses due to rising interest rates, regardless of their credit quality. Emerging Market Debt. Significant upward pressure on domestic interest rates and a corresponding widening of credit spreads could negatively impact prices in emerging debt markets. Municipal Securities. The Priorities cite Puerto Rico and Detroit as examples of municipalities whose financial distress has harmed investors. The Priorities state that particularly at-risk municipalities include those with significant debt maturing in the near- to mid-term, unrated issuers, and issuers with low levels of capital and insufficient liquidity. Baby Bonds (bonds issued in small denominations). FINRA is concerned that retail investors may not understand the risks of investing in baby bonds, which offer exposure to small, emerging, and financially distressed companies through business development companies ( BDCs ). The Priorities state that these investments present 4

5 significant liquidity risk due to a thin secondary market, and could potentially harm investors who are forced to sell prior to maturity. III. Board Oversight Considerations The Guidance Update and the Priorities are directed to fund advisers and FINRA member firms, respectively, and not to fund boards. Nevertheless, the guidance may be useful to fund boards in considering their oversight responsibilities with respect to fixed income funds. While the issues raised in the guidance are not novel and in many cases have been the subject of discussion by fund advisers and fund boards for some time, the issuance of the guidance may provide an opportunity for fund boards to revisit the issues raised in the guidance, and consider whether the advisers to their funds have robust mechanisms in place to mitigate the risks presented by the current environment. Fund boards may wish to consider the following issues in response to the guidance: Risk Oversight Considerations Do board members have an understanding of the liquidity needs of the funds they oversee, the sources of liquidity, and the factors that may affect liquidity? What is the nature and frequency of reporting to the board on liquidity issues? Does the adviser provide enhanced reporting in times of market stress? Do board members have an understanding of the types of stress testing performed by the adviser? Have the factors used in stress testing changed in response to changes in the fixed income markets? Have the results of stress testing impacted the management of the funds from a risk perspective? What is the nature and frequency of reporting to the board on stress testing? Disclosure Considerations Have fixed income fund prospectus disclosures been enhanced to address the risks presented by the changes to the fixed income markets and monetary policy? Are such risks adequately disclosed in shareholder reports, marketing material, and other shareholder communications? * * * BUSINESS 5