The SEC’s Division of Investment Management recommends that fixed income fund advisers take steps to assess portfolio risk in light of “potential market volatility” and review the adequacy of related prospectus disclosures.

In particular, the staff suggests that fund advisers “consider taking” the following steps:

• Assess and stress-test liquidity during normal and stressed environments, taking into account sources of liquidity over 1-day, 5-day, 30-day and possibly longer periods;

• Conduct more general stress-tests and scenario analysis to assess how interest rate hikes, widening spreads and price shocks, increased market volatility and reduced liquidity affect portfolio values;
• Conduct risk management evaluations based on these assessments to determine appropriate risk management strategies and actions under the circumstances at a fund level and at a complex level;
• Communicate with fund boards so that they understand not only the risk exposures and liquidity position of the fund, but also the fund’s ability to navigate changing interest rate conditions and market volatility; and
• Review shareholder communications to ensure that disclosures are adequate in light of any additional risks due to recent events in the fixed income market and the potential impact of tapering quantitative easing and/or rising interest rates, including the potential for periods of volatility and increased redemptions.

These recommendations come against a backdrop of what the staff characterized as “increased volatility” in the bond market during June 2013, as investors considered indications that the Federal Reserve Board would soon wean the markets away from its “quantitative easing” program, followed by a general rise in interest rates.

In light of these market developments, the staff believes that bond fund advisers should evaluate their risk management procedures and the adequacy of fund disclosures.  Fund boards should review their procedures to ensure that they provide appropriate oversight of the bond funds.

The guidance suggests that the staff senses market uncertainty on the horizon and is urging bond fund advisers to be prepared.  We would not be surprised if future regulatory examinations look at how bond fund advisers are preparing for the possibility of interest rate volatility.