The mutual fund industry has yet to catch on to the full implications of the SEC's approval of a new set of rules that would likely alter their investing behavior in the municipal bond market.
Even after months since the rules were approved, the fund industry is not engaged, outside of a few closed circles. If these rules are enacted, open-end mutual funds and ETFs that invest in municipal securities are likely to become more risk-averse in a variety of ways that have implications for issuers and other investors that perhaps have not been fully considered by executives.
The proposal, in brief, Rule 22e-4, would:
• Force funds to classify the liquidity of its assets under management based on the number of days it would take to sell the asset. The assets would be put into six different buckets based on the days it would take (between one day and more than 30 days) to sell the asset for cash. Factors to take into account for liquidity include trading volume, bid-ask spreads and volatility, among others.
• Make the 15% suggested ceiling on illiquid assets allowed to be in a fund assets an actual limit and not just guidance. Illiquid is defined as unable to sell an asset within seven days at about the value at which the fund has valued the investment.
• A fund would be required to determine a percentage of its assets that must be invested in cash and those which can be converted into cash within three days at a price that does not materially affect the funds' net asset value. The amount of minimum portfolio liquidity to which funds would have to adhere to would be based on a set of market-related factors established by the SEC.
Mutual funds make up nearly one-fifth of all municipal bond investors, according to the latest data from the Federal Reserve. They are also the most visible investor with weekly fund flow data reported in the media and closely followed by the industry.
Because of this visibility, funds have an outsized effect on the market's daily sentiment, and in the end, the borrowing costs for states and localities. While it is not clear how these liquidity risk-management programs will fully play out or how the SEC will treat municipals as it pertains to the three-day minimums, this new set of rules would likely force many portfolio managers to change the composition of their portfolios and make future investments with increased prudence. It is safe to say fund managers will be more likely to favor higher-rated credits, larger-volume issuers, shorten the duration of their portfolios, and keep more cash on hand.
The net impact of this rulemaking will be that it is likely going to increase the cost of issuance for smaller-volume issuers, which make up the bulk of the issuer community.
Mutual fund portfolio managers would also have to tread more carefully with issuers of lower ratings, placing a challenging hurdle for the plethora of high-yield funds in the space. Portfolio managers may also have to moderate their investments on the long-end of the curve as shorter maturities are not as sensitive to rate volatility as are longer duration securities. As such, a steeper yield curve could be an end result.
There are two other items that SEC staff notes in its report that could end up making liquidity risk-management even more challenging for municipals. First, staff notes the homogeneity of assets under management in a municipal bond mutual or exchange-traded fund (especially for state-specific funds).
As most funds hold 95% or more in municipals because of the tax strategy, municipal funds do not have the same diversity that other mutual fund types hold. This possibly means liquidity measurements will be more stringent when it comes to municipals. Second, staff notes that under current practice, muni funds tend to sell cash when facing redemptions instead of actual securities (or bonds). As such, it suggests the threshold for cash requirements for municipals might have to be higher as a result.
The impact on state and local governments at a time when rates appear to be rising before the year is out and an increased focus on the importance of public infrastructure should be considered when putting limitations on mutual fund investments.
These proposals are also coming on the heels of new bank rules as far as new coverage ratios are concerned with the implementation of Basel III that will change the way banks investment in municipals to a certain extent and change the way they approach offering letters of credit to municipal issuers and direct placements, as well. Cumulatively, these new rules are hindering important demand elements for municipalities at a critical juncture.
The argument can be made that these new hurdles for mutual funds would aid the continued rise of the separately managed account business that has seen massive growth in the municipal space over the last five years. SMAs make sense for many individuals, but it would further the structural changes the industry needs to accommodate these investment vehicles. It would also likely add to the challenges of long-bond issuers as SMAs are largely focused 10-years and in.
NON-TRADITIONAL INVESTOR RISES
Finally, with assumed less demand for higher-yielding credits, the rise of the non-traditional investor in the space is only likely to grow. Puerto Rico's woes continue, and with Chicago, New Jersey and Detroit continuing to make headlines, it would not be surprising to see the so-called hedge or distressed buyer get more engaged in the space, especially as credit spreads widen out because of less mutual fund investment there.
The House Financial Services Committee in November passed legislation that would direct Federal regulators to classify municipals at higher level than currently applies under the liquidity coverage ratio tiers for bank investors. If the industry wants to keep the current municipal bond investment community in its current form, maybe there is room to put some additional language as it pertains to SEC Rule 22e-4. Those who wish to comment on the Rule to the SEC have until just before the year is out to do so.
- Matt Posner is a public finance consultant.