May 31, 1994
TO: SEC RULES COMMITTEE NO. 57-94
RE: INSTITUTE LETTER TO N.Y. ATTORNEY GENERAL CONCERNING MUTUAL
FUNDS AND LEVERAGE
__________________________________________________________
The Institute recently sent a letter to G. Oliver Koppell, the
Attorney General of the State of New York, to clarify an issue
concerning mutual funds and leverage. The issue arose in the
context of a letter from Mr. Koppell to SEC Chairman Arthur Levitt
concerning the N.Y. Attorney General's investigation of and
settlement with a municipal bond mutual fund that invested a
substantial portion of its assets in inverse floaters. (See
Memorandum to SEC Rules Members No. 31-94, dated May 2, 1994.)
Copies of both letters are attached.
In his letter to Chairman Levitt, Mr. Koppell suggested that
fund purchases of "leveraged" inverse floaters may violate the
limits under the Investment Company Act on leveraging by investment
companies. The Institute's letter explains that inverse floaters
do not raise the same leveraging concern that Section 18 of the Act
is intended to address, i.e., the risk of losses in excess of a
fund's capital. Rather, the maximum amount that a fund that
purchases inverse floaters has at risk is the amount it invested in
such instruments.
The Institute's letter notes that the "leverage
characteristics" of inverse floaters refer to their relative
sensitivity to changes in interest rates and resulting potential
volatility. The letter suggests that the impact of such
investments should be taken into account in connection with
disclosures to investors concerning a fund's overall interest rate
risk. Insofar as funds can increase or decrease their exposure to
interest rate risk in a variety of ways (through derivatives or
otherwise), however, the Institute's letter expresses the view that
it would be inappropriate to single out a particular type of
instrument, such as inverse floaters, for limitations that would
not apply to the fund's other investments.
Frances M. Stadler
Associate Counsel
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