(PUB) Investing 2016

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The New Bond-Fund Rules Income Strategist | Eric Jacobson

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.com

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-