SEC warns money funds against investing in volatile securities such as derivatives.

WASHINGTON -- The Securities and Exchange Commission warned tax-exempt and other money market funds on Friday against investing in volatile derivatives or adjustable rate securities that could generate significant losses and erode the funds' value.

The warning, which the SEC made in a letter sent to the Investment Company Institute, comes as several money market fund sponsors have had to pump cash into their funds so that losses from derivatives would not drive the net asset value below $1 per share.

Under the SEC's Rule 2a-7, money market funds are supposed to maintain stable net asset values, which most funds interpret to mean about $1 per share.

In its letter, the SEC said it is particularly concerned about:

* Inverse floaters, leveraged floaters, and other securities whose interest rate reset provisions are based on a formula that magnifies changes in interest rates;

* "CMT floaters" or other securities whose interest rate reset provisions are tied to long-term interest rates so that a change in the slope of the yield curve could result in the value of the instruments falling below par;

* Securities on which interest is not paid above a certain level, such as capped floaters, or that cease to pay any interest when a certain level is reached, such as "range floaters;" and

* "COFI floaters" and other securities whose interest rate reset provisions are tied to an index that materially lags short-term interest rates.

"These securities share the common characteristic that, at the time of issuance, changes in interest rates or other conditions that can reasonably be foreseen to occur during their term, will result in their market value not returning to par at the time of an interest rate adjustment," the SEC said.

The commission urged money market funds and their advisers to reexamine their portfolios to determine whether they hold any of these products.

Funds that do hold such products should consult with their board of directors and trustees about "a plan to dispose of the securities in an orderly manner consistent with the interests of the funds' shareholders," the SEC said.

Any such action should be monitored by the board and documented so that it can be made available to the SEC upon request, the commission said.

For reprint and licensing requests for this article, click here.
MORE FROM AMERICAN BANKER