Recently, the staff of the SEC’s Division of Investment Management issued guidance suggesting certain information that advisers to fixed income funds and ETFs may wish to provide boards regarding risk management and disclosure regarding changing market conditions in fixed income markets. The guidance also suggests that boards “consider discussing with fund advisers the steps these advisers are taking in this area.”
The guidance discusses the current state of the fixed income markets, noting the importance of good risk management and disclosure “as the Federal Reserve Board contemplates the possible end of both quantitative easing and the period of near zero interest rates that has persisted for the last five years.” The guidance contrasts the current market from other periods of net outflows from fixed income funds, noting the current size of the bond market is approximately five times the size of the market in 1993 and 1999 (or the last time bond funds experienced net outflows as a result of rising interest rates). In addition to the enormous growth in the size of the bond markets, the guidance also notes the significant reduction in market-making capacity, which has the potential to decrease liquidity and increase volatility.
In light of the current size and structural issues in the bond market, the IM staff suggests that advisers consider the following actions:
- Assess and stress test liquidity, including assessments of the “needs and sources of fund liquidity 1 day, 5 days, 30 days, and potentially longer periods.”
- Conduct more general stress tests/scenario analysis that include the following factors, among others, “interest rate hikes, widening spreads, price shocks to fixed income products, increased volatility and reduced liquidity.”
- “Evaluate what risk management strategies and actions are most appropriate in response to changing fixed income market conditions at a fund and/or the complex level. These may include decisions around portfolio composition, concentrations, diversification and liquidity, among other factors.”
- Consider what information should be provided to fund directors “so that they are informed of the risk exposures and liquidity position of the fund, and the fund’s ability to manage through changing interest rate conditions and potentially increased fixed income market volatility.”
- “Should also assess the adequacy of disclosures to shareholders in light of additional risks due to changes in the fixed income markets.” If the adviser finds that additional disclosure is necessary, “the fund should consider the appropriate manner of communicating risks to shareholders (e.g., prospectus, shareholder reports).”