The Securities and Exchange Commission staff yesterday warned of deficiencies and weaknesses in the valuation and liquidity of high-yield municipal bond fund portfolios, as well as looming disclosure problems found during recent examinations of SEC-registered firms.
The letter said funds with higher average credit quality, fewer unrated securities, and fewer distressed and defaulted securities were generally less likely to have issues regarding valuation and liquidity. It also noted that liquidity is an important consideration for fund managers to ensure that they are able to redeem fund shares within seven days, as required by securities law.
The 17-page compliance alert letter, which includes three pages discussing municipal market issues, was composed by the SEC's Office of Compliance, Inspections and Examinations, and is unsigned. It does not refer to any individual firms by name and lists its concerns only in general terms.
Turning to disclosure issues, the letter warns that high-yield funds often did not disclose the increased risk with respect to liquidity and valuation. For example, examiners said they found multiple situations where the percentage of illiquid securities held by a fund dramatically increased and the fund did not disclose: the increase and the risks associated with it; what effect, if any, the increase may have on the fund's ability to redeem investor shares in a timely manner; and what steps, in any, the fund could take to dispose of some of the illiquid securities to bring the percentage of illiquid holdings to an "appropriate" level. The letter does not define what an appropriate level is.
Because many high-yield municipal bond funds invest in securities that trade rarely, if at all, in the secondary market, price quotes for such securities are often not readily available, the SEC said. Limited market activity usually results in the funds' boards determining the fair value of these instruments for net asset value purposes, with the aid of pricing services' price estimates, the letter said.
But SEC staff wrote that they are concerned about lax oversight by fund boards of the accuracy of prices provided by third-party pricing services. Boards should review communications between portfolio management personnel and pricing services to substantiate the independent of the pricing service, the SEC wrote.
SEC staff also wrote that a fund's disclosure about third-party pricing might be misleading if the fund reported that its pricing service provided "independent" values but the service relied on the fund to provide information at times, "which may have resulted in stale review periods and stale valuations" for a number of securities that are exempt from SEC registration.
The SEC also found that some funds were unable to sell securities at approximately the evaluated prices provided by a pricing service, which may present a concern for examiners if a fund's board does not consider this information when subsequently evaluating the accuracy of the evaluated price provided by the pricing service.
The commission staff also warned about so-called cross trades, in which an adviser's trading of securities among client accounts creates risks that securities will be "dumped" from one client account to another, that the securities may be mispriced because they are not traded in the open market, or that one client may otherwise be disadvantaged. And the staff encouraged the use of electronic records to allow for more efficient analysis and review of fund records for valuation anomalies and patterns requiring further research.
Separately, the SEC last week approved amendments to the Municipal Securities Rulemaking Board's Rule G-11 on new issue syndicate practices, Rule G-12 on uniform practice, and Rule G-8 on books and records. The amendments consolidate the syndicate practices provisions into G-11, as well as note the requirements for the settlement and record keeping of joint or similar accounts respectively in G-12 and G-8. The amendments, which became effective upon approval, also correct certain cross-references in the rules.
