Fixed Income Signals: A Red Alert for Compliance and Valuations?

by Deborah Prutzman, The Regulatory Fundamentals Group

The SEC recently issued guidance about risk management in the fixed income market in light of the prospect of the Fed tapering its quantitative easing program and triggering a rise in interest rates. It noted that the net assets of bond funds are at “near-historic highs” with much of the growth coming only recently. According to the release, which is available here, bond funds have increased by over $2 trillion since the end of 2008. This concerns the SEC because it sees evidence to indicate that structural changes today make the market more likely to suffer from decreased liquidity and increased volatility should bond prices decline. The release is directed at fixed income mutual funds and exchange-traded funds; however alternative managers, fund boards and investors may find the analysis beneficial.

For compliance personnel in firms that advise on fixed-income securities, the release is an important heads-up regardless of whether the advised clients are mutual funds, ETFs, alternatives, managed accounts or even individual investors. At the most basic level, it may signal concerns the SEC could focus on during examinations. Topics discussed include stress testing, disclosures to investors and directors, and risk evaluation strategies.

Equally as important is that any substantial change in market forces should place management and compliance on a red alert with respect to valuations.

Decreased liquidity and declining prices in any market might be a recipe for a misguided staff to conclude that market prices either are not obtainable or do not reflect inherent value. This type of thinking led to a plethora of litigations and settlements on valuations in the past few years. For example, see the cases against Morgan Keegan (fund board failed to satisfy pricing responsibilities), Mizuho Securities USA (falsified assets to obtain higher credit ratings) and Commonwealth Advisors (sold overpriced assets from one client to another client).

Now is a good time to remind staff of valuation policies and how they apply–even in down markets. It is also a good time to confirm that everyone is familiar with the role they play in the valuation process.

We noted in December (here) that the SEC is looking for the “tone at the top” in the valuation process. That article explains the reasons why managers must make sure that they and any committees:

i. consistently do what their policies say,

ii. in a meaningful way–by acquiring all needed information in a timely fashion and devoting the time needed for a full evaluation, and

iii. having done the above, maintain a full documentary record.

It goes without saying that a satisfactory process can only be achieved if committee members and staff generally have clarity and accountability as to expectations. In times of change a key expectation must be that, however difficult the conversation, “bad news” will be escalated to senior management.

Failure to follow these steps could generate a whole new set of enforcement proceedings in the valuation arena. And, should they occur, these new cases are likely to arise in a harsher and less forgiving environment.

How can RFG help? RFG can help you confirm whether your valuation processes and procedures meet the above standards and are adequately understood by all involved in the process. For further information go to www.regfg.com

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