During the fall, the SEC initiated a sweep examination of fixed-income funds due to concerns over potential shortages in bond fund liquidity. Examiners from the SEC have been evaluating investment managers’ ability to sell certain debt instruments if liquidity for such instruments decreases and urging advisers to stress test their portfolios to ensure that they can meet redemption requests during long periods of market volatility and illiquidity. Additionally, examiners have been scrutinizing disclosures relating to the potential effects of a rise in interest rates on fixed-income investments.
The SEC’s increased concern regarding fixed-income funds stems in part from the Federal Reserve’s anticipated departure from policies fostering a near zero percent interest rate environment. In a recent speech, SEC Commissioner Daniel Gallagher echoed this concern, noting that there is a “clear and present danger of a liquidity cliff in the debt markets.” He stated that the debt markets have grown exponentially in recent years due to low interest rates, while dealers have decreased their inventories in response to new regulatory constraints. As interest rates rise, he noted, outflows from high yield and less liquid debt investments may drive bond prices down, resulting in a liquidity crisis.
In January, the SEC’s Division of Investment Management issued an IM Guidance Update, which provided steps for bond funds to consider when preparing for changing market conditions in interest rates.