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NEW YORK, Dec 14 (LPC Reuters) - Under new rules from the US Securities and Exchange Commission (SEC), investment firms will be allowed to raise loan mutual funds but may be forced to defend their decision to invest in products deemed less liquid by the regulator.
In October the SEC voted to adopt rules to improve the liquidity risk management of open-end mutual funds and exchange-traded funds (ETFs), which are popular investments in retirement savings accounts.
The regulator wants to ensure that funds can meet any redemption requests. It has criticized long settlement times as a potential liquidity risk and highlighted trades in the US$870bn US leveraged loan market that take almost 20 days to close.
Going forward, the SEC can also ask managers to explain why their investment strategy is appropriate for open-end funds, which allow investors to redeem their money daily.
"There is no question the SEC is very focused on this and is going to be looking when funds put their liquidity plans together," said Elliot Ganz, general counsel at the Loan Syndications and Trading Association (LSTA), adding that managers need to be "very serious about how they manage liquidity risk."
Under the rules, which are part of the SEC's effort to enhance monitoring and oversight of the asset management industry, firms will have to classify each investment into four buckets based on the number of days it will take to convert to cash without significantly changing the value.
The SEC lists loans as an example of a less liquid investment, which it describes as an asset that can be sold in seven days but takes longer to close than that time period, which comes as a relief to the industry. There was concern that loans could be classified as illiquid under the original 2015 SEC proposal, David Wang, an analyst at Moody's Investors Service, said. Funds can only hold 15% of illiquid assets, which could have made it difficult to raise new open-end loan funds.
"The very good news is that the Commission recognized that loans are not illiquid - they trade in a way that is liquid and the slower settlement times do not make them illiquid but pushes them into a category that is less liquid - and that certainly allows for the continued existence and issuance of loan mutual funds," said Ganz.
Loan mutual funds and ETFs had US$126bn of assets under management in November, according to Thomson Reuters LPC data. Investors poured US$1.8bn into the funds in the week ending December 7, in the largest inflow since August 2013, according to Lipper.
Inflows are expected to continue as loan funds are viewed as a hedge against rising interest rates. Floating-rate loans pay investors a set amount plus Libor, and interest payments increase as rates rise. The Federal Reserve on Wednesday raised rates by 25bp, the first increase in a year.
The SEC's ability to quiz managers about how investing in less liquid loans is appropriate in funds with daily redemptions is causing concern and could encourage some firms to pick structures that lock up investor money for extended periods of time, sources said.
"The SEC staff will likely say, justify this strategy and explain to us on the record how the fund is going to comply with its liquidity risk management obligations," said Kenneth Burdon, counsel at law firm Skadden, Arps, Slate, Meagher & Flom.
The SEC was previously able to ask for additional information after firms filed a registration statement for a new open-end mutual fund, but this may be the first time that the regulator has put this option in writing.
"Essentially the SEC is using what I think of as its bully pulpit to urge fund management and boards to think harder about whether holding securities with longer settlement periods is appropriate with this type of fund," said Nathan Greene, co-head of the asset management group at law firm Shearman & Sterling.
Open-end funds need to meet redemption requests in seven days. It took 19.1 days on average to close a loan trade in the third quarter, according to IHS Markit. High-yield bond trades close in three days.
The gap between the time it takes to settle a loan trade and the time a fund has to meet redemptions still remains, which creates a possible scenario where firms may struggle to complete loan sales fast enough to meet withdrawal requests.
One way of addressing this mismatch is with an investment fund that has quarterly or bi-annual redemptions, said Steve Tu, a Moody's analyst.
The new rule may encourage advisers and fund boards, which ultimately have to approve new investment products, to consider whether a closed-end structure is more appropriate for a loan fund, Burdon said.
An SEC spokesperson declined to comment. (Reporting by Kristen Haunss; Editing by Michelle Sierra and Tessa Walsh)