On January 15th, the SEC's Division of Investment Management ("IM") issued a Guidance Update entitled, "Risk Management in Changing Fixed Income Market Conditions" (available here).
In the piece, IM raises questions as to whether volatility in the fixed income markets would be materially increased by an uptick in bond fund outflows in the face of decreased dealer inventories.
While assets in bond mutual funds and ETFs have grown rapidly in recent years, dealer capacity in the fixed income markets appears to have undergone fundamental changes. Today, primary dealer capacity is at similar levels to 2001, while bond mutual fund and ETF assets have grown by a factor of four since that time...A significant reduction in dealer market-making capacity has the potential to decrease liquidity and increase volatility in the fixed income markets. [Pages 3-4 of the Guidance Update, Footnotes Omitted]
Mention is not made of whether alternative liquidity sources (i.e., other than primary dealers) exist that could have a mitigating effect on volatility.
SO, WHAT'S AN INVESTMENT ADVISER TO DO?
According to IM, investment advisers can consider at least four possible actions.
- Assess and Stress Test Liquidity
Advisers may consider assessing fund liquidity needs during both normal and stressed environments for varying time periods - 1 day, 5 days, 30 days and potentially longer.
- Conduct More General Stress-Tests/Scenario Analysis
Advisers may consider assessing the impact (beyond just liquidity) of various "stress-tests and/or other scenarios on funds". Specific examples provided by IM included interest rate hikes, widening spreads, price shocks to fixed income products, and increased volatility and reduced liquidity.
- Risk Management Evaluation
Advisers may consider using the outcomes of any assets to evaluate what risk management strategies and actions are most appropriate at the fund and complex level, in light of changing fixed income market conditions. Specific decisions cited by IM related to portfolio composition, concentrations, diversification and liquidity.
- Communicate with Fund Boards
Advisers may consider whether additional information could be provided to fund boards, so that directors are informed of a fund's liquidity positions, risk exposures, and ability to manage through potential volatile interest rate conditions.
And, last but certainly not least, the adequacy of existing mutual fund disclosures should be considered. Specific consideration could be given to whether existing disclosures adequately address additional risks due to changes and recent events in the fixed income markets, such as the effect of a tapering of quantitative easing and rising interest rates (perhaps even decreased dealer inventories, although there is no mention of this factor in the enumerated list provided by IM in the Guidance Update).