Surging market volatility is making regulators increasinglyconcerned that bond funds have loaded up on hard-to-sellassets.

The U.S. Securities and Exchange Commission (SEC) has stepped upexams of money managers, while pushing mutual funds to test whetherthey could satisfy customer redemptions during periods of financialstress, said people with knowledge of the plans. Federal Reserveofficials have reached out to the biggest investment firms to quizthem on markets after price swings for stocks, currencies, andcommodities hit a 13-month high last week, said a person briefed onthe discussions.

“I certainly received a lot of calls from many regulatorsworldwide over the last few weeks asking me what's going on,”BlackRock Inc. Chief Executive Officer Laurence D. Fink said in anOct. 21 Bloomberg Television interview. The New York-based firm isthe world's biggest money manager with $4.5 trillion of assets.

A focus for regulators is ensuring that investors know thedangers of putting their cash in funds that trade daily yet investin less-liquid assets such as loans and junk bonds. Last year,customers plowed a record $62.9 billion into leveraged-loan mutualfunds, bringing their share of non-bank institutional lending tomore than 30 percent from less than 20 percent in 2012, accordingto Lipper and Loan Syndications and Trade Association data.

SEC spokesman John Nester and New York Fed spokesman JonathanFreed declined to comment.

Concern is mounting that as the U.S. central bank exits fromalmost six years of easy-money policies, debt that's benefited mostfrom the stimulus will lose value and investors as yields rise.

Mutual funds, exchange-traded funds, and households are now thebiggest holders of dollar-denominated corporate and foreign bonds,accounting for 30 percent of the debt, up from less than 20 percentin 2007, according to International Monetary Fund data.

Examiners from the SEC's inspections group have made it apriority in recent months to ask money managers about their abilityto sell certain bonds if trading dries up, said the people, whoasked not to be named because the reviews are private. The SECunit, which tries to spot market risks and ensure firms arecomplying with securities laws, is also checking disclosures thatfund managers have made about how a jump in interest rates mightaffect their debt investments.

A big concern is that some firms are investing ininfrequently-traded leveraged loans and high-yield corporate bonds,while adhering to a mutual-fund requirement that clients be able topull their cash daily.

'Hot Potato'

In times of stress, “it's a game of hot potato,” Tony Crescenzi,a strategist and fund manager at Pacific Investment Management Co.(Pimco), said in an Oct. 21 Bloomberg Television interview. “Whenone wants to go to sell, it's more difficult, so one has to be verycareful about liquidity.”

Worries about funds being able to meet redemptions areoverblown, said Brian Reid, chief economist at the InvestmentCompany Institute, the mutual-fund industry's biggest trade group.Mutual-fund and ETF investors provide a stable source of cash anddon't move it around that frequently, he said. This is especiallytrue now, with a growing proportion of older Americans investing inbonds as they approach retirement.

The majority of the U.S. mutual-fund industry's $15 trillion ofassets is invested in frequently-traded government debt andstocks.

Officials in the SEC division that oversees mutual funds arealso urging firms to stress-test their portfolios to make sure theycan pay out redemptions during long periods of market turmoil, saidthe people.

The jawboning follows up on guidance the SEC published inJanuary that advised money managers to check whether their fundscould endure economic strain that lasts 30 days or longer and gaugethe impact of specific scenarios, including spreads betweengovernment debt and other bonds widening, price shocks tofixed-income investments, or a surge in interest rates.

While the broad U.S. bond market has gained an average 5 percenta year since the end of 2008, investors are growing concerned thatdebt could post losses as yields rise because of less Fedstimulus.

Regulators and investors got a taste of what's at stake in June2013, when then-Fed Chairman Ben S. Bernanke surprised traders bysignaling that the central bank might start curtailing its recordbond buying. Yields surged and volatility jumped for assets rangingfrom stocks to commodities.

Unforeseen Events

Some of the SEC's recent discussions with money managers havebeen triggered by unforeseen events. After Bill Gross's surpriseSeptember announcement that he would leave Newport Beach,California-based Pimco and stop running the firm's $202 billionTotal Return Fund, the regulator initiated daily discussions withthe biggest fund companies to quiz them on asset flows and whetherthe star manager's departure had led to any bond-marketdisruptions, one of the people said.

The Fed and Office of the Comptroller of the Currency (OCC) havealso stepped up scrutiny of banks that sell leveraged loans to mutual funds. The regulators shifted to aloan-by-loan review of each deal in recent months after bankslargely ignored guidance issued last year that laid out whatsupervisors considered excessively risky transactions, BloombergNews reported earlier this month, citing people familiar with thepolicy change.

IMF analysts have called on regulators to bridge the gap betweenmutual-fund shares that trade daily and underlying assets that maytake weeks to sell. An option that should be considered is makingit harder for investors to flee certain funds all at once, theanalysts wrote in a report this month.

The idea is radical, because federal rules are based on thepremise that retail investors shouldn't find themselves trapped infunds they can't pull money from. At the same time, the popularityof mutual funds has been fueled, in part, by the ease at whichclients can take cash out.

Jay Baris, a New York-based partner and chairman of theinvestment-management practice at the Morrison & Foerster LLPlaw firm, said a lot of the onus falls on fund managers to makesure they're not buying assets unsuitable for “hot money” clientswho might disappear quickly.

“Liquidity of the bond markets is in the SEC's cross-hairs,” hesaid. “Knowing your customer becomes more critical or more relevantwhen planning.”

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