The Securities and Exchange Commission is investigating whether some mutual funds have overstated the value of risky municipal bonds that are thinly traded, according to people familiar with the matter.
The Wall Street Journal notes that the SEC probe, which is part of the agency's broader effort to investigate possible abuses in the municipal-bond market, comes at a time of concern about financial stresses on municipal borrowers.
The agency's concern is that investors in high-yield muni-bond mutual funds could be misled about the true value of their investment, according to the paper. These people cite the weakened muni market of the past few months. Fund managers have had to sell high-quality liquid assets in their portfolio to come up with cash as investors have withdrawn money from muni funds at an unprecedented rate.
As The Journal notes, in high-yield funds, which invest in "junk"-rated bonds, that selling can leave these bonds representing a higher proportion of the remaining assets. That change increases the odds that mismarking of these less-liquid assets overstates a fund's value, masking losses.
From mid-November through Friday, muni-bond mutual funds have suffered net outflows of about $24.7 billion, according to Thomson Reuters unit Lipper FMI.
A spokesman for the SEC declined to comment for the paper.
Valuation problems don't necessarily signal bad intentions. Many municipal junk bonds are held by only a few of the approximately three dozen mutual funds that specialize in such risky bonds. Many junk muni-bonds are thinly traded, making it potentially difficult to identify the current value of the bonds, some analysts say.
"There just aren't that many investors transacting in them thus compromising the integrity of the evaluation," Thomas Doe, CEO of research firm Municipal Market Advisors, told the paper.
Valuation questions about illiquid securities have long been a concern among market participants and regulators, including during the subprime-mortgage loan crisis.
The paper recounts an SEC case against broker-dealer Morgan Keegan & Co., in which regulators allege that a subprime fund manager there manipulated the prices of bond funds that were having losses. In April 2010, the SEC charged Morgan Keegan and two employees with civil fraud.
Rated junk muni-bonds total about $54 billion in value, a small slice of the $2.9 trillion municipal debt market.