WASHINGTON – A Securities and Exchange Commission proposal designed to bolster liquidity risk management among open-end funds would likely reduce the funds' appetite for municipal securities and deter infrastructure projects, the Government Finance Officers Association warned.
The new rule and amendments to other rules are too rigid and do not account for the subjective nature of classifying a fund's assets, said the Independent Directors Council, led by a governing council of Investment Company Institute member funds, and the Asset Management Group of the Securities Industry and Financial Markets Association.
The groups raised their concerns in comment letters on the SEC's proposal, which was released on Sept. 22 in an effort to prevent investor runs on funds in times of fiscal stress.
Under the proposal, mutual funds and other open-end management investment companies would have to have liquidity risk management programs that classify portfolio assets into six categories based on how quickly the assets could be converted to cash. Money market funds would be exempted from the proposal.
The liquidity risk program, which a fund's board would have to approve, would include categories for assets that could be liquidated in: one business day; two to three business days; four to seven calendar days; eight to 15 calendar days; 16 to 30 calendar days; and more than 30 calendar days. Funds would have to report the liquidity classifications for their assets by category to the SEC on revised forms.
Under the program, no more than 15% of a fund's assets could be illiquid. The fund also would have to determine the minimum percentage of its net assets that could be converted into cash within three business days.
The GFOA said that while it understands the SEC's desire to add safeguards to prevent heavy redemptions in times of fiscal stress, the proposal overlooks some of the key features of municipal securities, which made up about $612 billion of the assets of mutual funds and exchange-traded funds at the end of 2015, according to Morningstar Inc. data.
"GFOA would like to work with the commission to include language in the final rule that achieves [the SEC's] objective without simultaneously discouraging funds from purchasing securities from investment-grade municipal issuers," said Dustin McDonald, director of the GFOA's federal liaison center who authored the group's letter.
He added that trading volume, which the proposal is based on, is not by itself a reliable indicator of future liquidity for munis. Highly-rated munis tend to trade less frequently than other securities because the bonds often form the core of an investor's holdings, he said. In times of fiscal stress, bonds have a higher trading volume because of their attractiveness to potential investors, he added.
If the proposal were passed in its current form, the GFOA said, funds would move away from long-term bonds and also reduce their demand for the bonds of smaller, less-frequent issuers because they are generally less liquid and unfamiliar to many investors in the market.
"Losing these investors will likely drive up the cost of issuing municipal bonds, increasing costs of infrastructure project delivery to state and local governments and taxpayers," McDonald said. "The burden of these costs will be particularly difficult for smaller governments to absorb, and potentially result in forgoing some critical infrastructure projects in these communities."
The GFOA letter also criticized the federal government for, on the one hand saying it supports infrastructure investment, while on the other, putting out proposals that discourage it like this one and another last year that does not classify munis as high quality liquid assets.
SIFMA's AMG made similar comments, saying the categories and factors for liquidity contained in the rule "are far more likely to be features of the established equity markets than the existing markets for many types of fixed-income securities."
The group said one big problem is that the system would require the funds to classify the assets by individual CUSIPs, when in practice fixed income securities are frequently traded based on an issuer's overall debt structure instead of on the individual CUSIPs.
"Analyzing liquidity by CUSIP is particularly unhelpful in the case of municipal securities," the group added. "Only about 1% of outstanding municipal security CUSIPs trade on a typical day. In spite of their infrequent trades, high quality municipal securities are often extremely liquid, illustrating that low trading volumes or a low number of specific active markets for a security does not necessarily equate to low liquidity."
Both SIFMA's AMG and the ICI's IDC offered more flexible proposals for the SEC to consider.
IDC proposed shifting from the "overly granular" six-category classification to a three-category system that would classify assets into most liquid, illiquid, and intermediate liquidity assets. The group also would replace the three-day liquid asset requirement with one to have processes to ensure sufficient liquidity based on the specific fund's investment objective.
The AMG said its plan would try to balance "robust program requirements" with "leaving funds adequate flexibility to manage liquidity risk effectively."
The "inherently incompatible" six-category plan would be replaced with one that has four categories, one for highly liquid assets, two for less liquid assets, and one for illiquid assets.
The funds would have the capability of taking "appropriate qualitative and quantitative factors" into account and, instead of the three-day liquid asset minimum, would require fund managers to determine whether they should identify a target percentage of highly liquid assets that their funds should maintain, AMG said.
