October 5, 1989
TO: SEC RULES MEMBERS NO. 55-89
CLOSED-END FUND MEMBERS NO. 49-89
UNIT INVESTMENT TRUST MEMBERS NO. 52-89
RE: INVESTMENT MANAGEMENT LETTER ON PROSPECTUS DISCLOSURE ON
HIGH YIELD BONDS
__________________________________________________________
The Division of Investment Management has distributed a
letter to investment company registrants that sets forth its
views on the nature of prospectus disclosure required of
investment companies that invest in high yield bonds. The
requested disclosure includes discussion of specific risk
factors, as well as a tabular or narrative presentation of the
percentages of total assets represented by bonds in different
rating categories, and by unrated bonds. The letter, a copy of
which is attached, requests all registrants to take "immediate
steps" to review current disclosure and, to the extent necessary,
amend such disclosure. The letter states that any such
amendments may be effected by the stickering process under Rule
497 under the Securities Act. The letter also states that the
General Instructions to Form N-1A and Guide 3 thereto should be
consulted in order to determine whether the required disclosure
should be included in the prospectus or the Statement of
Additional Information.
The letter states that registration statements of investment
companies that invest in bonds rated other than high-grade should
"highlight" the risk factors associated with such investments
that were discussed in the recent SEC Release on disclosures
about securities issued in leveraged transactions. (Relevant
excerpts from that Release were previously sent to you. See
Memorandum to SEC Rules Members No. 27-89, Closed-End Fund
Members No. 23-89 and Unit Investment Trust Members No. 28-89,
dated May 22, 1989.)
The staff letter also recommends that certain specified risk
factors associated with high yield bonds be disclosed in the
registration statement. These include:
(1) Youth of Market. The letter states that many high
yield securities have been issued after the last recession.
Accordingly, the impact of an economic downturn on the market and
on the value of such securities should be disclosed.
(2) Sensitivity to Interest Rates and Economic Changes .
The letter notes that high yield bonds are generally less
sensitive to interest rate changes but states that they may be
more sensitive to adverse economic changes or individual
corporate developments. It notes that zero coupon and payment-
in-king bonds also may have a higher degree of interest rate
sensitivity.
(3) Payment Expectations. The letter states that bonds
with call provisions may present risks due to the exercise of
such provisions in a declining interest rate environment.
(4) Liquidity and Valuation. Investment companies are
requested to disclose, to the extent there is no established
secondary market, the impact of this on their ability to
accurately value securities and to dispose of them. (Specific
investment policies to reduce "liquidity risk" should also be
disclosed.) Disclosure of the effects of adverse publicity and
investor perceptions is also requested. The letter states that
any material change in a registrant's portfolio liquidity would
require stickering.
(5) Congressional Proposals. Investment companies are
requested to disclose the possible impact of new laws and
proposed new laws on the high yield market (e.g., the savings and
loan bill, tax proposals).
(6) Taxation. Investment companies are requested to
disclose special tax considerations involved in investing in high
yield bonds such as zero coupon and payment-in-kind securities.
(7) Credit Ratings. Investment companies are requested to
disclose the nature of the lowest rating of securities in which
they invest. In addition, disclosure should be made concerning
the risks of using ratings to evaluate bonds (e.g., the failure
of rating agencies to reflect changes on a timely basis). The
letter states that funds should be "continuously monitoring" high
yield bond issuers in view of the limitations of rating agencies.
Unit investment trusts should disclose any added risks of having
a portfolio that is not actively managed.
In addition to the risk factors and special considerations
set forth above, prospectuses should contain disclosure of the
percentages of total assets represented by (1) rated securities,
separated by rating category; (2) unrated bonds as a group, and
(3) unrated bonds determined by the fund's board to be comparable
in quality to rated bonds, separated by rating category. Any
"material deviations" in future years should be "explained in
future filings."
We will keep you informed of further developments in this
area.
Craig S. Tyle
Assistant General Counsel
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