Tucked away in the SEC adopting release for the new money market rules is valuation guidance for all registered investment companies and business development companies (referred to herein as “funds”).

Use of Amortized Cost Valuation

Key Take Away: When a fund uses amortized cost valuation, the guidance requires the fund to actively monitor both market and issuer-specific developments that may indicate that the market-based fair value of a portfolio security has changed, resulting in the use of amortized cost valuation no longer being appropriate.

The SEC generally believes that a fund may only use the amortized cost method to value a portfolio security with a remaining maturity of 60 days or less when it can reasonably conclude, at each time it makes a valuation determination, that the amortized cost value of the portfolio security is approximately the same as the fair value of the security as determined without the use of amortized cost valuation. Existing credit, liquidity, or interest rate conditions in the relevant markets and issuer specific circumstances at each such time should be taken into account in making such an evaluation.

Accordingly, it would not be appropriate for a fund to use amortized cost to value a debt security with a remaining maturity of 60 days or less and thereafter not continue to review whether amortized cost continues to be approximately fair value until, for example, there is a significant change in interest rates or credit deterioration. Instead, the SEC believes the fund should evaluate the amortized cost each time it calculates its net asset value or otherwise values its portfolio securities.

A fund’s policies and procedures should be designed to ensure that the fund’s adviser is actively monitoring both market and issuer-specific developments that may indicate that the market-based fair value of a portfolio security has changed, and therefore the use of amortized cost valuation for that security may no longer be appropriate.

Other Valuation Matters

Key Take Away: When a fund holds securities that do not have readily available market quotations because they are not actively traded in the secondary markets, such securities are generally valued based upon “mark-to-model” or “matrix pricing” estimates.

In matrix pricing, portfolio asset values are derived from a range of different inputs, with varying weights attached to each input, such as pricing of new issues, yield curve information, spread information, and yields or prices of securities of comparable quality, coupon, maturity, and type. A fund might also consider evaluated prices from third-party pricing services, which may take into account these inputs as well as prices quoted from dealers that make markets in these instruments and financial models.

Fair Value for Thinly Traded Securities

Key Take Away: This portion of the guidance makes it clear that thinly traded securities need to be fair valued by taking into account market conditions existing at the time of valuation because the fair value of a security is the amount that a fund might reasonably expect to receive for the security upon its current sale. So, for example, a fund holding debt securities generally should not fair value these securities at par or amortized cost based on the expectation that the fund will hold those securities until maturity, if the fund could not reasonably expect to receive approximately that value upon the current sale of those securities under current market conditions.

The SEC acknowledged that matrix pricing and similar pricing methods involve estimates and judgments, which might introduce some “noise” into portfolio security prices, and therefore into a fund’s NAV per share when rounded to one basis point. However, the SEC continues to believe that market-based prices of portfolio securities provide meaningful information, and does not believe that amortized cost generally provides better or more accurate values of securities that do not frequently trade or that may or may not be held to maturity given a fund’s statutory obligation to investors to satisfy redemptions within seven days (and a fund’s disclosure commitment to generally satisfy redemptions much sooner).

The SEC has concerns about the use of the amortized cost method in valuing portfolio securities because its use may result in overvaluation or undervaluation in comparison to the actual markets. For this reason, there is a preference embodied in the Investment Company Act that funds value portfolio securities taking into account current market information. This ties to fair value for thinly traded securities because as a general principle, the fair value of a security is the amount that a fund might reasonably expect to receive for the security upon its current sale. So, fair value by its very nature requires taking into account market conditions existing at that time.

Use of Pricing Services

Key Take Away: This part of the guidance makes it clear that a board of directors needs to take special care when it approves the use of a pricing service because the board has a non-delegable responsibility to determine whether an evaluated price provided by a pricing service, or some other price, constitutes a fair value. So, in approving a pricing service, a board should consider, among other things, the following:

  • The inputs, methods, models, and assumptions used by the pricing service to determine its evaluated prices.
  • How the inputs, methods, models, and assumptions used by the pricing service are affected (if at all) as market conditions change.
  • The quality of the evaluated prices provided by the pricing service.
  • The extent to which the pricing service determines its evaluated prices as close as possible to the time as of which the fund calculates its net asset value.
  • Whether the board has a good faith basis for believing that the pricing service’s pricing methodologies produce evaluated prices that reflect what the fund could reasonably expect to obtain for the securities in a current sale under current market conditions.

As noted above, many funds use evaluated prices provided by third-party pricing services to assist them in determining the fair values of their portfolio securities. With regard to such pricing services, the SEC noted that the evaluated prices provided by pricing services are not, by themselves, readily available market quotations or fair values. So, reliance on a pricing service must be done with care.

Care must be taken because a fund’s board of directors has a non-delegable responsibility to determine whether an evaluated price provided by a pricing service, or some other price, constitutes a fair value for a fund’s portfolio security. In this regard, directors are required to satisfy themselves that all appropriate factors relevant to the value of securities for which market quotations are not readily available have been considered, and to continuously review the appropriateness of the method used in valuing each issue of security in a fund’s portfolio.