The following analysis of the SEC’s Mutual Fund Liquidity Rule is courtesy of the LSTA’s Meredith Coffey. It was first published on www.lcdcomps.com on Jan. 15. 

The SEC’s Mutual Fund Liquidity Rule: What it says—and what it might mean
The LSTA responded recently responded to the SEC’s proposal on Open-End Mutual Fund Liquidity. Perhaps to the surprise of some, the LSTA agrees with many tenets of the SEC’s proposal. However, in a number of places, the proposal veered toward prescriptive requirements that many funds—including loan mutual funds—would be hard-pressed to meet. Below, we discuss the SEC’s proposal, what we agree with—and what we respectfully disagree with. In addition, we recap our research in two areas: tracking mutual fund redemption performance in three volatile periods and stress testing loan mutual fund flows.

Meredith Coffey

What is the SEC’s Open End Mutual Fund Liquidity Proposal? In September 2015, the SEC released a proposal to strengthen open-end mutual fund liquidity risk management programs. As the SEC correctly noted, meeting shareholder redemptions—and performing the liquidity risk management that ensures redemptions are met—is critical to open-end fund management. To ensure that liquidity risk management gets proper attention, the SEC made three major proposals. First, it would require each fund to prepare a liquidity risk management program that would i) assess and manage the fund’s liquidity risk; ii) classify and monitor each portfolio asset’s level of liquidity, based on the days it would take to convert the asset to cash; and iii) designate a minimum amount of portfolio liquidity. Second, the proposal would require each fund to make public the liquidity classification of each individual asset, information about redemptions, and swing pricing if applicable. Third, it would permit mutual funds to use swing pricing in their shares. In addition, the Proposal would codify the long-used definition of “illiquid asset” as an asset that could not be sold within seven calendar days at approximately the value ascribed to it by the fund.

How does the proposal affect loan mutual funds…and what is the LSTA’s response? Open end loan mutual funds would be required to meet the liquidity, disclosure, and reporting requirements of the SEC proposal. It is important to note that, as proposed, syndicated loans would not be included in the 15% illiquid asset bucket.

The LSTA believes it is entirely appropriate that open-end funds have adequate policies and procedures to address meeting investor redemption requests. In turn, we strongly support the SEC’s requirement that open-end funds and ETFs have formal liquidity risk management programs designed to address and manage liquidity risk, classify and monitor liquidity of investment portfolios, and maintain a minimum level of liquidity. We also support reporting to the SEC and other regulators regarding portfolio liquidity. We support the 15% illiquid asset test, as proposed. (Caveat: We oppose any change that might alter the definition of 15% illiquid assets to a “convert to cash” concept. We discuss how loan funds’ liquidity facilities bridge any gap between when a liquid loan is sold and when the cash is available from settlement.)

Despite our general support, some of the rule’s components have the potential to significantly (and negatively) affect all $15 trillion of open-end mutual funds, including the $100 billion of open-end daily liquidity loan mutual funds. Areas of concern include the proposed liquidity classifications, the three-day liquid asset minimum, and public disclosure of liquidity determinations. The following is just one example of how the principle of the rule clashes with market realities. Under the rule, the manager must determine if it could convert an asset to cash—without materially affecting the asset’s price—within i) 1 business day; ii) 2–3 business days; iii) 4–7 calendar days; iv) 8–15 calendar days; v) 16–30 calendar days; or vi) in more than 30 calendar days. In reality, it can be difficult to determine whether an asset sale by an investor has been responsible for any price movement, even after the sale. It would be even more difficult to make that prediction prior to the sale and put the asset in exactly the right day count based on that prediction. This process presumes a divination ability that simply does not exist.

How have open end loan mutual funds performed in periods of stress? Loan mutual fund managers proactively and effectively manage liquidity; this is why funds have weathered significant periods of stress and have always met investor redemptions. In just the past 10 years, there have been three significant periods of stress. Between July 2007 and December 2008, loan mutual funds experienced more than $15 billion of outflows—a very substantial proportion of their assets. In August 2011 alone, thanks to global turmoil and the Fed promising to keep interest rates low for two years, open end loan mutual funds experienced $7 billion of outflows—or 13% of their assets. In 2013, expecting interest rates to rise, investors put significant money back into loan mutual funds. But once it became clear in early 2014 that interest rates still were not going to rise in the near term, open end loan mutual funds saw more than $38 billion—or 20% of their assets—redeemed between April 2014 and January 2015. In all of these cases, open end mutual funds met redemptions.

How do open end loan mutual funds meet three-day redemptions in stress periods if loan settlement is slow? So loan mutual fund managers successfully met redemptions in stressed periods—but how is that possible? After all, commentators have observed a gap between the time that loan sales settle—a median 12 days—and mutual fund investor redemptions that must be met in three days. There are two key facts here. First, the industry is working to reduce settlement times— and in fact they have fallen two days since 2014. Second, managers have developed techniques to manage their portfolios in light of extended loan settlement periods. In particular, loan mutual fund managers i) hold cash, ii) invest in securities that settle in three days (T+3 securities), and iii) secure a line of credit from banks to ensure access to liquidity. In an August 2015 survey, the LSTA collected information from open-end funds and ETFs with a total of $72 billion in assets; this is over half the open-end loan fund and ETF universe. The median fund had 3.5% of assets in cash, another 6.1% in T+3 securities—and a material line of credit with a bank. Thus, managers have considerable access to liquidity to bridge any gap between when loan sales settle and when investor redemptions must be met.

How can open end loan mutual funds ensure that they will perform in future periods of stress? History indicates that loan mutual funds have met redemptions in periods of stress in the past. However, that doesn’t necessarily guarantee that funds will meet redemptions in the future. And that is why loan fund managers typically stress test their portfolios to ensure that they can meet redemptions in volatile markets. The LSTA comment letter included stress tests of two types of managers: i) one with large cash and T+3 securities holdings, but a smaller line of credit, and ii) one with small cash and T+3 securities holdings, but a larger line of credit. The stress tests included two scenarios; i) a short fast shock of a one-day 10% redemption, and ii) two consecutive months of record 13% outflows. In both cases, both managers were able to show the ability to meet investor redemptions. Through stress tests like these, as well as active management, open end loan fund managers demonstrate the ability to meet redemptions in foreseeably stressed scenarios.

Meredith Coffey
mcoffey@lsta.org

This guest analysis first appeared on www.lcdcomps.com, LCD’s subscription site offering complete news, analysis and data covering the global leveraged loan and high yield bond markets. You can learn more about LCD here.