WASHINGTON —A proposal from the Securities and Exchange Commission threatens to eliminate bank loan funds, the Investment Company Institute told the agency in a comment letter obtained by American Banker.
Bank loan funds are mutual funds or exchange-traded funds that buy adjustable-rate loans made by banks or other financial institutions, usually made to below-investment-grade companies — although these loans are often secured by collateral. They're particularly attractive in rising interest rate environments because they have flexible interest rates, but carry higher default risk.
The funds grew substantially after the 2008 financial crisis, reaching their peak in 2013 and remain an important part of the financial market plumbing for banks and other financial institutions.
The SEC proposal in question would expand the definition of an "illiquid" investment, tipping a number of funds past the existing 15% cap on illiquid assets. Bank loan funds are particularly vulnerable to this change, the ICI said in its comment letter, filed alongside the regional group ICI Southwest.
"If adopted, the proposed liquidity rule amendments would eliminate funds investing primarily in bank loans, a category that long has been beneficial to retail investors," the group said in the comment letter. "While the amendments would be fatal to these funds, they also would adversely affect other funds that hold bank loans."
The amendments have already faced significant pushback. In September,
Currently, the SEC's liquidity rule requires funds to classify each portfolio investment into one of four buckets — highly liquid, moderately liquid, less liquid and illiquid. The proposal would eliminate the less liquid bucket and expand the illiquid bucket, making it "impossible" for bank loan funds to comply with the 15% threshold, the ICI said.
The ICI, in the letter, pushes back against the idea that bank fund loans pose a large enough threat to justify these changes, and says that there are less stringent measures the SEC and the funds could take to mitigate the risks that bank loan funds present.
"In their approximately 25-year history, bank loan funds have operated successfully within the open-end fund regulatory structure, and to date, no bank loan fund has suspended redemptions," the group said.
In its proposal, the SEC raised concerns with a key feature of bank fund loans: an unusual settlement structure that takes longer than normal. The SEC said that this might be problematic, and that bank loan funds are generally less liquid than normal stocks or bonds.
The Federal Reserve's vice chair for supervision said the central bank is weighing regulatory and supervisory changes to liquidity management standards. Current approaches, he said, might not be able to contend with the speed of modern runs.
"We recognize that this fund category has a different liquidity risk profile because of the settlement conventions of bank loans — they can take somewhat longer to settle in cash after a fund and the counterparty enter a binding trade," the ICI said. "Precisely for this reason, these funds use liquidity risk management tools and mitigants."
Those tools include maintaining a buffer allocation to assets that can be quickly converted to cash, and lines of credit as well as lending arrangements with other funds to speed up settlement.
Instead of pushing bank loan funds into a category that would eliminate them, the ICI said that it supports the SEC's 10% highly liquid investment minimum for funds investing primarily in securities that would generally not be settled in cash in seven calendar days or less.
"Consistent with the proposal, this would be the 'floor' for these funds, and these funds still would be required to comprehensively assess their liquidity risk factors and consider whether a higher figure would be appropriate," the group said.
ICI also said that it backs amending the rule's liquidity risk factors to address longer-settling investments, along with guidance that outlines the SEC's expectations around liquidity risk mitigants.
Should the SEC go ahead with its amendments as laid out, the ICI warned that it could upend a large market — one that provides capital to growing businesses.
"Bank loan funds currently hold approximately 90 billion in net assets, and it is highly unlikely that these assets would easily transition into closed-end funds or liquidated in an orderly and pain-free manner," the group said. "Instead, fund sponsors and boards would make difficult and costly decisions."
Other open-end funds hold bank loans, and the SEC could dampen demand for them if they're pushed into the illiquid bucket, the ICI said.
"Open-end funds are managed to avoid breaching (or, in most cases, even approaching) the 15% illiquid investment limit," the group wrote. "Even when not breaching or approaching the limit, funds likely will seek to avoid the negative perception that may accompany holding a larger percentage of fund assets in 'illiquid investments' (the stigma certainly would be exacerbated by the SEC's proposed requirement for public reporting of bucketing information)."
It's unclear to what degree existing bank loan fund shareholders would redeem their shares should a number of bank loan funds be liquidated: "We can, however, predict net outflows would occur. Funds and advisors likely would close these funds to new investments during their windup periods, and existing investors to some degree would redeem prior to final liquidations. Fund flows would be entirely in one direction — out. It would be ironic if these funds' unblemished record in meeting redemptions on a timely basis would be undone not by a global pandemic, but by SEC rule amendments," the ICI wrote.
