NEW YORK, August 26 (Reuters) - Some of the largest US loan mutual funds have increased their cash and bond holdings in the last year, which can make it easier to repay investors in times of market volatility, as regulators warn about the possible perils of insufficient liquidity.
Cash and bond holdings at five of the biggest US loan mutual funds have increased by nearly 8.5% since the second quarter of 2014, according to Moody's Investors Service, as more investors withdrew money from the funds.
Assets in loan Exchange-Traded Funds (ETFs) have fallen 17% in the last 12 months and assets in five of the largest loan mutual funds are about 27% lower, Moody's said.
Liquidity is becoming a key focus as regulators including the US Securities and Exchange Commission (SEC) cite long settlement times in the US$840bn leveraged loan market as a concern and possible threat to liquidity.
Leveraged loans, which provide financing to non-investment grade companies like Delta Air Lines, can take about 19 days to settle, which could pose problems if funds need to sell loans quickly to repay investors seeking to redeem their investments in times of market stress.
Mutual funds can hold cash or invest in bonds to help them meet redemptions as needed, Stephen Tu, a senior analyst at Moody's in New York, said in an interview. Most funds also have a line of credit that can be drawn down, as some managers did during the credit crisis, to meet investors' requests for repayment, sources said.
"As an active fund manager, we have several different tools to manage our funds and one is to use cash and securities for liquidity," said William Housey, senior portfolio manager at First Trust Advisors in Wheaton, Illinois.
Shorter bond settlement times of up to three days, "helps to mitigate some of the liquidity headline risk that has been around loans for a long time," Housey added.
Nearly one out of three Americans, more than 90 million people, have invested in registered funds, and since late 2009 assets in loan mutual funds and ETFs have increased by almost 400%, SEC Commissioner Kara Stein said in a June 15 speech.
There were 245 loan mutual funds with US$141bn in assets as of December 2014, according to the Loan Syndications & Trading Association, and four loan ETFs with about US$7bn in assets.
This year, investors have withdrawn US$8.8bn from loan mutual funds and ETFs, following record outflows of US$23.9bn in 2014 according to Lipper data. This contrasts with a record US$62.9bn of inflows into the funds in 2013, the data shows.
Increased redemption requests from investors continue to cause concern about slow settlement times.
Secondary trades of leveraged loans settled in an average 19.3 days last quarter, according to Markit; longer than the seven days recommended by the LSTA, and more than six times the three days that it takes bonds to settle.
"Funds investing in these loans could face liquidity challenges if a significant number of investors make redemption requests at the same time," the Financial Industry Regulatory Authority (FINRA) said in its 2015 Regulatory and Examination Priorities Letter.
In times of volatility, managers may increase cash holdings to help fund redemption requests.
Fidelity held 6.08% cash and 4.62% in fixed-rate bonds in its Fidelity Floating Rate High Income Fund as of June 30, according to its website. Its cash holdings were the largest among five of the biggest loan mutual funds, according to Moody's.
"We keep an appropriate level of cash balancing the opportunity in the market with the liquidity needs of our shareholders," a Fidelity spokesperson said in an e-mailed statement.
OppenheimerFunds seeks to keep the Oppenheimer Senior Floating Rate Fund fully invested at all times, according to Joseph Welsh, portfolio manager of the fund.
"Cash balances fluctuate based on a variety of factors such as timing of trades, settlements and flows," Welsh said in an e-mailed statement.
The First Trust Senior Loan Fund, a loan ETF, is allowed to move the entire fund to cash in certain circumstances.
"We've written language into our prospectus that allows us to go to 100 percent cash for defensive purposes," Housey said. "We have written the documents to give us as much flexibility as possible to weather a potential liquidity storm because we have to be thoughtful about the risks."
The fund held 14.03% in bonds as of July 31, according to its website.
"For temporary defensive purposes and during periods of high cash inflows or outflows, the fund may depart from its principal investment strategies and invest part or all of its assets in these securities or it may hold cash," the fund's prospectus said.
Increased attention on liquidity may become more important as the SEC has said that it is updating its rules related to registered funds on the 75th anniversary of the Investment Company Act of 1940. The regulator is also considering changing liquidity-management rules. (Editing by Tessa Walsh and Leela Parker Deo)