3.01 This chapter provides brief descriptions of certain financial instruments of investment companies. Consideration should be given to FASB Accounting Standards Codification (ASC) 815, Derivatives and Hedging; 820, Fair Value Measurement; 460, Guarantees; and 860, Transfers and Servicing, in connection with accounting and financial statement presentation for these financial instruments.

Money Market Investments

3.02 Short term investments, such as short term government obligations, commercial paper, bankers’ acceptances, and certificates of deposit (CDs), may be bought at their face amount or a discount or premium from their face amount.

3.03 Funds may value money market investments that mature within a relatively short period (for example, 60 days) at amortized cost, which often approximates fair value. However, the impairment of the credit standing of the issuer or unusual changes in interest rates can affect their fair value significantly. In those circumstances, amortized cost may not approximate the fair value of such investments.

3.04 SEC Release No. 33-9616, Money Market Fund Reform; Amendments to Form PF, provides guidance on the use of amortized cost for valuation. Registered investment companies and business development companies (BDCs) may use amortized cost to value debt securities with remaining maturities of 60 days or less if fund directors, in good faith, determine that the fair value of the debt securities is their amortized cost value, unless the particular circumstances warrant otherwise. The SEC generally believes that a registered investment company or BDC may only use the amortized cost method to value a portfolio security with a remaining maturity of 60 days or less when it can reasonably conclude, at each time it makes a valuation determination, that the amortized cost value of the portfolio security is approximately the same as the fair value of the security as determined without the use of amortized cost valuation. Existing credit, liquidity, or interest rate conditions in the relevant markets and issuer specific circumstances at each such time should be taken into account in making such an evaluation. Accordingly, it would not be appropriate for a registered investment company or BDC to use amortized cost to value a debt security with a remaining maturity of 60 days or less and thereafter not continue to review whether amortized cost continues to approximate fair value until, for example, there is a significant change in interest rates or credit deterioration. The SEC generally believes that a registered investment company or BDC should, at each time it makes a valuation determination, evaluate the use of amortized cost for portfolio securities, not only quarterly or each time the registered investment company or BDC produces financial statements.

3.05 In SEC Release No. 33-9616, the SEC places additional conditions on the use of amortized cost valuation by certain registered money market funds. One of the key structural features of the final rule, effective during 2016, is that institutional prime and municipal money market funds (as defined in the rule) will be required to transact at a floating net asset value rounded to the fourth decimal place (for example, $1.0000), based on the most recently determined value of portfolio securities. Although these funds are permitted to use amortized cost valuation for securities with maturities of 60 days or less, the SEC has stated its belief that, if a floating net asset value (NAV) fund’s use of amortized cost to value a portfolio security that matures in 60 days or less were to result in a difference in the fund’s NAV used to transact in fund shares and the fund’s NAV calculated without the use of amortized cost, such a difference would not be compatible with the guidance provided in the final rule.¹

3.06 The guidance of paragraph 3.05 does not apply to “retail” or “government” money market funds, as defined in the rule, who may use the amortized cost method of valuation to value their entire portfolios (subject to the conditions in SEC Rule 2a-7). However, no registered money market fund may use the amortized cost method to value individual securities when performing “shadow pricing” pursuant to SEC Rule 2a-7(g)(1)(i)(A).

3.07 Funds acting as money market funds but not registered with the SEC, including some funds supervised by other regulators, may still continue to value their entire portfolios at amortized cost. Policies issued by any applicable regulators should be considered in determining to what extent, if any, the use of amortized cost is permitted as an approximation of fair value for short-term instruments.

Repurchase Agreements

3.08 A repurchase agreement (repo) is, in its simplest form, the purchase of a security at a specified price with an agreement to sell the same or substantially the same security to the same counterparty at a fixed or determinable price at a future date with a stipulated interest rate. A repo allows the investment company to transfer uninvested cash to a seller, usually a broker, for a security. The seller agrees to repay cash plus interest to the investment company in exchange for the return of the same or substantially the same security. Because a repo between the two specific parties involved is not transferable, a repo has no ready market. The repo’s settlement date is usually specified in the agreement. When the repo’s settlement date (or maturity date) is equal to the settlement date (or maturity date) of the underlying security, the repurchase agreement is commonly referred to as a repo-to-maturity.

3.09 Repos are usually entered into with banks, brokers, or dealers. According to SEC Release No. 10666 under the Investment Company Act of 1940 (the 1940 Act), the investment company should always be sure that the repo, including accrued interest, is fully secured by the fair value of the collateral that it has received.² Rule 5b-3 under the 1940 Act states that for purposes of Sections 5 and 12(d)(3) of the 1940 Act, the acquisition of a repo may be deemed to be an acquisition of the underlying securities, provided that the obligation of the seller to repurchase the securities from the investment company is fully collateralized at all times by cash items, U.S. government securities, or other securities. When the collateral is other than cash or U.S. government securities, such securities are required to consist of securities that the fund’s board of directors (or its delegate) determines at the time the repurchase agreement is entered into are (a) issued by an issuer that has an exceptionally strong capacity to meet its financial obligations on the securities collateralizing the repurchase agreement and (b) sufficiently liquid that they can be sold at approximately their carrying value in the ordinary course of business within seven calendar days.

Reverse Repurchase Agreements

3.10 A reverse repurchase agreement (reverse repo or resale) is, in its simplest form, the sale of a security at a specified price and interest factor with an agreement to repurchase the same or substantially the same security from the same counterparty at a fixed or determinable price at a future date. A reverse repo allows the investment company to transfer possession of a security to a buyer, usually a broker, for cash. The investment company agrees to repay cash plus interest in exchange for the return of the same security. A reverse repo accounted for as a collateralized borrowing does not qualify for sale accounting under FASB ASC 860.³

U.S. Government Securities (Treasury Bills, Notes, and Bonds)

3.11 U.S. government negotiable debt obligations, known as Treasuries, are secured by the government’s full faith and credit and issued at various maturities. These securities clear through book entry form at the Federal Reserve Banks. The income from Treasury securities is exempt from state and local, but not federal, taxes. Treasuries include the following:

•     Treasury bills. Short term securities with maturities of 1 year or less are issued at a discount from face value. Auctions of 4, 13, and 26 week bills take place weekly, and the yields are watched closely in the short-term markets for signs of interest rate trends. Many floating-rate loans and variable-rate mortgages have interest rates tied to these bills. The Treasury also auctions 52 week bills once every 4 weeks. Treasury bills are issued in minimum denominations of $100. Individual investors who submit a noncompetitive bid are sold bills at the discount rate determined at auction. Treasury bills are the primary instrument used by the Federal Reserve in its regulation of the money supply through open market operations.

•     Treasury notes. Intermediate securities with original maturities of 2 to 10 years. Denominations start at $100. The notes are sold through a bank or broker or via auction.

•     Treasury bonds. Long term debt instruments with an original maturity of 30 years issued in minimum denominations of $100.

3.12 In addition to these basic security types, the government issues other structures, such as Separate Trading of Registered Interest and Principal of Securities also known as stripped Treasury securities and Treasury Inflation-Protected Securities.

Municipal Notes and Bonds

3.13 Municipal securities are issued by states, cities, and other local government authorities to fund public projects. The interest on these bonds is usually exempt from federal taxes and under certain conditions is exempt from state and local taxes. Municipal notes usually mature in less than three years. They are usually designated as tax, revenue, or bond anticipation notes because they are redeemable on the receipt of anticipated taxes or revenues or on financing from the proceeds of municipal bonds. They include short term tax-exempt project notes issued by public housing or urban renewal agencies of local communities with payment of principal and interest guaranteed by the U.S. government. Another common municipal note is a variable rate demand note, which is a floating rate instrument with frequent reset coupon rates and usually a put feature.

3.14 Municipal bonds are principally classified as general obligation bonds and revenue bonds. General obligation bonds represent the issuer’s unqualified pledge, based on its full faith, credit, and taxing power, to pay principal and interest when due. Revenue bonds are payable from revenues derived from a particular class of facilities or other specific revenue sources. Tax-exempt industrial development bonds are usually revenue bonds and do not carry the pledge of the municipal issuer’s credit, but may be supported by the credit of a private not-for-profit institution (health care or educational institution, for example) or for-profit business entity (utility or industrial company, for example). Yields on municipal bonds depend on a variety of factors, including market conditions, maturity date, ratings assigned to the issue, credit support, and tax-exempt status. Some municipal bonds may be prerefunded by the issuer whereby the bonds are collateralized by securities or U.S. Treasury obligations. Because many of these are guaranteed by Treasury obligations, they often maintain an AAA rating and may trade at a premium over other municipal bonds. Other common municipal bonds include municipal lease obligations, which represent a certificate of participation in the cash flows for certain projects or services, whose funding must be appropriated annually by the municipality.

3.15 Among investment companies, municipal notes and bonds are held primarily in the portfolios of both tax-exempt money-market and municipal bond funds and generally require special considerations for valuation. They are traded in a dealer market in which little published price information is available. New issues of municipal notes or bonds are usually sold by competitive bidding. Subsequent market quotations may be obtained from dealers in those securities.

3.16 A significant decline in the fair value of a municipal security that appears to relate to the issuer’s creditworthiness may indicate the probability of default. Comparisons of the fair value of the security with the fair value of similar securities or a downgrading of the issuer’s credit rating may indicate such decline.

Insured Portfolios

3.17 As stated in FASB ASC 946-20-05-12, many municipal bond funds, primarily those organized as unit investment trusts with fixed portfolios, arrange for insurance for the payment of principal and interest when due. The insurance applies to portfolio securities only while they are owned by the fund, and its coverage is not transferable to buyers of the securities. That arrangement differs from those in which the issuer of the securities (the municipality) acquires the insurance, which makes the insurance feature an element of the securities and becomes transferable on changes in ownership. According to FASB ASC 946-20-25-11, if the insurance applies only to the fund’s portfolio, it does not have a measurable fair value in the absence of default of the underlying securities or of indications of the probability of default; accordingly, the cost of the policy should be treated as an operating expense.

To Be Announced Securities

3.18 The term to be announced (TBA) is derived from the fact that the actual security that will be delivered to fulfill a TBA transaction is not designated at the time the trade is made. The securities that will ultimately be delivered upon settlement are “announced" 48 hours prior to the established trade settlement date. The fund trading TBA securities makes a forward commitment to purchase a preset principal amount at a preset price on a preset date in the future.

3.19 Funds may enter into TBA commitments with the intent to take possession of or deliver the underlying asset, but can extend the settlement (or roll the transaction). TBA commitments involve a risk of loss if the value of the security to be purchased or sold declines or increases, respectively, prior to settlement date; if the counterparty does not perform under the contract’s terms; or if the issuer does not issue the securities due to political, economic or other factors.

3.20 TBA securities are generally included in the portfolio of investments and are considered to be a regular-way transaction. At the time a fund enters into a commitment to purchase or sell a security, the transaction is recorded and the value of the security underlying the commitment is reflected in the fund’s net asset value. The price of such security and the date that the security will be delivered and paid for is fixed at the time the transaction is negotiated. No interest accrues to the fund until payment and delivery takes place. At the time that a fund enters into this type of transaction, the fund is required to have sufficient cash or liquid securities to cover its commitments.

3.21 Pursuant to recommendations of the Treasury Market Practices Group, which is sponsored by the Federal Reserve Bank of New York, a fund or its counterparty generally will be required to post collateral when entering into certain forward-settling transactions, including TBA transactions.

3.22 For long TBA positions, as with other long investments, the security name, par value, coupon rate, maturity date, cost (presented as part of the aggregate cost of investments) and value should be shown in the Schedule of Investments. For short TBA positions, the security name, par value, coupon rate, maturity date proceeds and value should be presented for each position in the securities sold short section of the Schedule of Investments. The TBA security should be designated as having been purchased or sold on a delayed delivery or when-issued basis, if the settlement extends beyond the “normal” settlement period.

When-Issued Securities

3.23 Some securities, principally municipal securities, are traded on a when-issued basis. A municipal securities underwriter solicits expressions of interest in a proposed issue and sends a when-issued price confirmation against which securities are delivered later when the terms of the issue are known. The securities usually begin trading on a when-issued basis on the issuance of the confirmation as if they had been issued a few days before the closing date.

3.24 Securities offerings are rarely aborted after when-issued trading begins. A when-issued security and the obligation to pay for the security should be recorded when the commitment becomes fixed, which is the date that the priced transaction confirmation is issued. When-issued securities for which the fund has not taken delivery are required to be identified in a registered investment company’s financial statements.⁴ Securities may also be bought on a delayed delivery contract under which the underwriter agrees to deliver securities to buyers at later specified dates.

Synthetic Floaters and Inverse Floaters

3.25 Many investment advisers use tax-exempt derivative securities as a way to increase the pool of creditworthy tax-exempt securities. These derivatives include synthetic floaters, under which issuers of such instruments use interest payments from long term municipal bonds, which may be coupled with an interest rate swap and a put feature, to pay the floating short term interest rates on the synthetic floater. The investor receives regular interest payments that are tied to short term municipal rates while the issuer earns the spread between the long term coupon rate and short term floating rate. This spread increases as interest rates decrease, and decreases as interest rates increase, which is known as an inverse floating yield. The investor may either hold the trust certificate representing ownership of the underlying bond to maturity or put it back to the issuer for cash.

3.26 In some instances, these synthetic securities are created by a fund depositing fixed-rate tax-exempt bonds or other types of bonds into a special purpose trust or Tender Option Bond (TOB) trust against which synthetic floating rate notes (floaters), as well as a residual security junior to the floaters (inverse floaters) are issued. The TOB trust sells the synthetic floaters to money market funds or other investors and transfers the cash proceeds of that sale as well as the inverse floater to the fund. The fund typically uses the cash proceeds of the sale to purchase additional portfolio securities. The holder of the inverse floater has rights to principal and any interest remaining after interest payments have been made on the floaters. The terms of the TOB trust often allow, upon unanimous consent of the holders of the inverse floaters, for the liquidation of the trust, with full repayment being made to the synthetic floaters and the underlying fixed-rate bonds being delivered to the holders of the inverse floaters. If the holders of the inverse floaters also participated in the formation of the TOB trust (that is, the inverse floater certificates were not acquired on the secondary market), FASB ASC 860 should be considered in evaluating the appropriate accounting and whether the initial transfer of the bond into the TOB trust and subsequent issuance of synthetic floaters would be considered a secured borrowing or sale.

3.27 If this transaction results in a secured borrowing by the fund, then Section 18 of the 1940 Act must be considered. Section 18 prohibits an open-end fund from issuing any senior security, except for a borrowing from a bank with 300 percent asset coverage, and generally requires a closed-end fund to have 300 percent asset coverage for any senior security that represents an indebtedness. Section 18(g) generally defines a senior security as any bond, debenture, note, or similar obligation or instrument constituting a security and evidencing indebtedness, and provides that senior security representing indebtedness means any senior security other than stock. The SEC staff has addressed TOB financings under Section 18 on multiple occasions in reviewing fund registration statements and in the context of other communications with various funds and their counsel. In particular, the SEC staff’s position is that a TOB financing involves the issuance of a senior security by a fund unless the fund segregates unencumbered liquid assets (other than the bonds deposited into the TOB trust) with a value at least equal to the amount of the floaters plus accrued interest, if any.⁵

3.28 The Volcker Rule. On December 10, 2013, the final Volcker Rule was published. Under the Volcker Rule, banking entities are restricted from, among other things, investing in or sponsoring covered funds (a term which includes TOB trusts). With banking entities precluded from performing some of the services they historically have provided under their TOB programs, a delineation has arisen between TOB trusts created prior to December 31, 2013, and TOB trusts created after that date.

Mortgage-Backed Securities

3.29 As defined by the FASB ASC glossary, mortgage-backed securities (MBSs) are securities issued by a governmental agency or corporation (for example, the Government National Mortgage Association [GNMA] or the Federal Home Loan Mortgage Corporation [FHLMC or Freddie Mac]) or private issuers (for example, the Federal National Mortgage Association [FNMA], banks, and mortgage banking entities). MBSs generally are referred to as mortgage participation certificates or pass-through certificates. GNMA is a U.S. government owned corporation that approves the issue of MBSs whose principal and interest are then fully guaranteed by the U.S. government. FNMA is a U.S. government sponsored entity that purchases mortgages, including mortgages backed by the Federal Housing Administration or guaranteed by the Veterans Administration and other conventional mortgages, and resells them to investors. Freddie Mac is a government sponsored entity that issues MBSs known as participation certificates. A participation certificate represents an undivided interest in a pool of specific mortgage loans. Periodic payments on GNMA participation certificates are backed by the U.S. government. Periodic payments on FHLMC and FNMA certificates are guaranteed by those corporations but not backed by the U.S. government.

3.30 An MBS is a pass-through security created by pooling mortgages and selling interests or participations in the MBS. In some instances the mortgage originator will continue to service the underlying mortgage, or the servicing may be sold to a subsidiary or another institution. Mortgage originators will usually pool mortgage loans and sell interests in the pools created. By selling MBSs, originators can obtain funds to issue new mortgages while retaining the servicing rights on the pooled loans. Principal and interest payments received from mortgagors are passed on to the MBS holders 45 days later for the GNMA, 55 days later for the FNMA, and 75 days later for Freddie Mac (45 days for gold Freddie Mac).

3.31 Mortgages are not homogeneous, and as a result different pools have different prepayment experience. MBSs are considered seasoned once they have been outstanding for four to five years. Investors are typically willing to pay more for seasoned mortgages than unseasoned mortgages because seasoned mortgages have payment experience, which investors use to make estimates of future prepayments. Unseasoned MBSs possess more unknown variables and, thus, are more sensitive to market volatility.

Adjustable Rate Mortgages

3.32 An adjustable rate mortgage (ARM) is a mortgage loan whose interest rate is reset periodically to reflect market rate changes. In addition, ARMs usually have caps that provide borrowers with some protection from rising interest rates. ARMs’ interest rates are usually calculated based on one of three indexes: (a) U.S. Treasury securities, (b) the Cost of Funds Index, or (c) average mortgage rates. Typically, ARM rates are reset every six months, one year, three years, or five years. ARMs are usually priced at a spread above the U.S. Treasury yield. In addition, the GNMA, the FNMA, and the FHLMC or private insurance companies guarantee many ARMs.

Collateralized Mortgage Obligations

3.33 Different kinds of collateralized mortgage obligation (CMO) structures exist, each of which has different cash flow characteristics. A security holder may invest in a CMO equity form (for example, trust interests, stock, and partnership interests) or nonequity form (for example, participating debt securities). Some of these structures include the following:

•     CMO bonds are bonds collateralized by either a pool of pass-through securities or a pool of mortgage loans and may be issued in several tranches having different maturities and interest rates. The cash flow from the pool of assets is used to pay the principal and interest on the bonds. The sequence of payments is deal specific and is modeled by the issuer.

•     CMO residuals represent the excess cash flows from MBSs or a pool of loans used as collateral for a CMO bond and include reinvestment income thereon after paying the debt service on the CMO and related administrative expenses. Cash flows are generated from the interest differential between the collateral for the CMOs and the CMO itself, the interest differential between the various classes of bonds, reinvestment income, and overcollateralization income. Many different kinds of CMO residuals, including floating-rate residuals; inverse floating residuals (inverse floaters [that is, residuals for which the interest rates vary inversely with floating rates]); and principal amortization class residuals, are available.

•     Interest-only (IO) and principal-only (PO) securities are created by splitting a traditional MBS or pool of loans into an IO and a PO portion. IO securities may have fixed or variable interest rates. Both IO and PO securities are subject to prepayments and therefore prepayment risk. IO investors are at risk for faster than anticipated prepayments and PO investors for slower than anticipated prepayments. Assumptions regarding the rates of prepayment play a significant role in the price of these securities. Because they may not pay a current coupon, prices of IOs and POs are more sensitive to changing interest rates than coupon bonds. They can be stripped from fixed or adjustable-rate loans or a pool of fixed-rate loans containing a range of different mortgage rates. The individual mortgages in those pools are subject to prepayment and default risk. PO securities issued by government sponsored entities (that is, the FNMA, the FHLMC, and so on) are usually fully or partially guaranteed against credit loss.

•     An IOette is an IO with a relatively low principal amount and high coupon rate. The principal and interest components of MBSs are sometimes separated and recombined in varying proportions to create synthetic coupon securities.

Real Estate Mortgage Investment Conduits

3.34 The real estate mortgage investment conduit (REMIC) is a form of CMO specially designated for federal income tax purposes so that the related income is taxed only once (to the security holder). A corporation, a partnership, an association, or a trust may elect to be a REMIC and many special purpose entities that issue CMOs, IOs, POs, and MBSs have elected to structure themselves as REMICs.

High-Yield Securities

3.35 As defined by the FASB ASC glossary, high-yield debt securities are corporate and municipal debt securities having a lower-than-investment-grade credit rating (BB+ or lower by Standard & Poor’s or Ba1 or lower by Moody’s). Because high-yield debt securities typically are used when lower-cost capital is not available, they have interest rates several percentage points higher than investment-grade debt and often have shorter maturities. These high-yielding corporate and municipal debt obligations are frequently referred to as junk bonds. As further explained in FASB ASC 946-320-05-4, they are typically unsecured and subordinate to other debt outstanding. Many issuers of high-yield debt securities are highly leveraged with limited equity capital. These inherent differences from investment grade bonds, including a market for such securities that may not always be liquid, may increase the market, liquidity, and credit risks of these securities as follows:

Market risk. In contrast to investment-grade bonds (the market prices of which change primarily as a reaction to changes in interest rates), the market prices of high-yield bonds (which are also affected by changes in interest rates) are influenced much more by credit factors and financial results of the issuer as well as general economic factors that influence the financial markets as a whole. Such factors often make it difficult to substantiate the market valuation of high-yield bonds.

Liquidity risk. The market risk is often heightened by liquidity risk (that is, the absence of centralized high-yield bond exchanges and relatively thin trading markets, which make it more difficult to liquidate holdings quickly and increase the volatility of the market price). There is generally no centralized or regulated procedure for pricing high-yield debt issues.

Credit risk. Issues of high-yield debt securities are more likely to default on interest or principal than are issues of investment-grade securities.

3.36 SEC yield formula calculations are required to be made using the specific guidelines presented in SEC Final Rule Release No. 33-6753. Yields calculated that way might not be the same as the interest reported in the financial statements. The ultimate realizable value and the potential for early retirement of securities should be considered when computing SEC yields. Management’s best estimates of ultimate realizable value should be reasonable. If current values of high-yield debt securities decline significantly from the issue price, computed yields may be higher than rates expected to be ultimately realized. To avoid unsound yield information, consideration should be given to capping yields of individual securities at some reasonable level and examining the underlying economic viability of the issuers.

Payment-in-Kind Bonds

3.37 As defined in the FASB ASC glossary, payment-in-kind bonds (PIK) are bonds in which the issuer has the option at each interest payment date of making interest payments in cash or additional debt securities. Those additional debt securities are referred to as baby bonds or bunny bonds. Baby bonds usually have the same terms, including maturity dates and interest rates, as the original bonds (parent PIK bonds). Interest on baby bonds may also be paid in cash or additional like-kind debt securities at the option of the issuer.

3.38 FASB ASC 946-320-35-10 states that the interest method should be used by an investment company to determine interest income on PIK bonds. The FASB ASC glossary defines the interest method as the method used to arrive at a periodic interest cost (including amortization) that will represent a level effective rate on the sum of the face amount of the debt and (plus or minus) the unamortized premium or discount and expense at the beginning of each period. As further explained in FASB ASC 946-320-30-4, PIK bonds typically trade flat (that is, interest receivable is included in the market value quote obtained each day). Accordingly, that portion of the quote representing interest income needs to be identified. The sum of the acquisition amount of the bond and the discount to be amortized should not exceed the undiscounted future cash collections that are both reasonably estimable and probable. Further, FASB ASC 946-320-35-11 notes that, to the extent that interest income to be received in the form of baby bonds is not expected to be realized, a reserve against income should be established.That is, it should be determined periodically that the total amount of interest income recorded as receivable, plus the initial cost of the underlying PIK bond does not exceed the current fair value of those assets.

Step Bonds

3.39 As defined by the FASB ASC glossary, step bonds are characterized by a combination of deferred-interest payment dates and increasing interest payment amounts over the bond lives. Thus, they bear some similarity to zero-coupon bonds and traditional debentures.

3.40 As noted in paragraphs 12–13 of FASB ASC 946-320-35, income on step bonds should be recognized using the interest method. Additionally, to the extent that interest income is not expected to be realized, a reserve against income should be established. The sum of the acquisition amount of the bond and the discount to be amortized should not exceed the undiscounted future cash collections that are both reasonably estimable and probable.

Put and Call Options

3.41 An option is a contract giving its owner the right, but not the obligation, to buy (call) or sell (put) a specified item at a fixed price (exercise or strike price) during a specified period (American option) or on a specified date (European option). Options may be exchange traded or over the counter. Options may be written on a variety of instruments, indexes, commodities or currencies. The buyer pays a nonrefundable fee (the premium) to the seller (the writer). An investment company may buy or write put and call options, if permitted, as disclosed in its prospectus. As consideration for an option, the buyer pays the writer a premium that is the maximum amount that the buyer could lose. That amount is influenced by such factors as the duration of the option, the difference between the exercise price and fair value of the underlying securities, price volatility, and other characteristics of the underlying securities. In return for the premium

•     a covered writer of a call option (a writer who owns the underlying securities) gives up the opportunity to profit from an increase in the fair value of the underlying securities to a point higher than the exercise price of the option outstanding but retains the risk of loss if the fair value of the securities declines.

•     an uncovered writer of a call option (a naked option) does not own the underlying securities but assumes the obligation to deliver the underlying securities on exercise of the option. An uncovered writer is exposed to the risk of loss if the fair value of the underlying securities increases above the strike price but has no risk of loss if the fair value of the underlying securities does not exceed the option exercise price.⁶

•     a writer of a put option is exposed to the risk of loss if the fair value of the underlying securities declines but profits only to the extent of the premium received if the underlying security increases in value because the holder of the option will not exercise it if the holder can obtain a greater price elsewhere. The writer is covered if a put option is bought on the same underlying securities with an exercise date equal to or earlier than the option that it covers and an exercise price equal to or greater than the option written.

3.42 After an option is written, the writer’s obligation may be discharged in one of the following ways:

a.     The option expires on its stipulated expiration date.

b.     The writer enters into a closing transaction.

c.     The option holder exercises the right to call (buy) or put (sell) the security (not applicable for index options).

3.43 The writer or buyer of an option traded on an exchange can liquidate the position before the exercise of the option by entering into a closing transaction. Such a transaction, in effect, cancels the existing position. The cost of a liquidating purchase, however, may be higher than the premium received for the original option. Because the writer or buyer can enter into a closing transaction, the option originally written may never be exercised. An option traded on an exchange is exercised only through the Options Clearing Corporation (OCC), the obligor on every option, by the timely submission of an exercise notice by the clearing broker acting on behalf of the exercising holder. The exercise notice is assigned by the OCC to a clearing broker acting on behalf of a writer of an option of the same series as the exercised option. The clearing broker is obligated to deliver the underlying security against payment of the exercise price. The assigned broker is selected randomly from clearing members having accounts with the OCC with options outstanding of the same series as the option being exercised.

3.44 Freestanding written put options and certain contracts that function as fair value guarantees on a financial asset that is owned by the guaranteed party, even when classified as derivatives under FASB ASC 815, are within the scope of the disclosure provisions of FASB ASC 460-10-50.⁷ Under those provisions in FASB ASC 460-10-50-4, guarantors are required to disclose the following information about each guarantee or each group of similar guarantees, even if the likelihood of the guarantor’s having to make payments under the guarantee is remote:

a.     The nature of the guarantee, including its approximate term; how the guarantee arose; the events or circumstances that would require the guarantor to perform under the guarantee; and the current status (that is, as of the date of the statement of financial position) of the payment or performance risk of the guarantee (for example, the current status of the payment or performance risk of a credit risk-related guarantee could be based on either recently issued external credit ratings or current internal groupings used by the guarantor to manage its risk). An entity that uses internal groupings should disclose how those groupings are determined and used for managing risk.

b.     The undiscounted maximum potential amount of future payments that the guarantor would be required to make under the guarantee, which should not be reduced by the effect of any amounts that may possibly be recovered under any recourse or collateralization provisions. If the terms of the guarantee provide for no limitation to the maximum potential future payments under the guarantee, that fact should be disclosed. If the guarantor is unable to develop an estimate of the maximum potential amount of future payments under its guarantee, the reasons why it cannot estimate the maximum potential amount should be disclosed.

c.     The current carrying amount of the liability, if any, for the guarantor’s obligations under the guarantee (including the amount, if any, recognized under FASB ASC 450-20-30 that deals with loss contingencies), regardless of whether the guarantee is freestanding or embedded in another contract.

d.     The nature of any recourse provisions that would enable the guarantor to recover any amounts paid under the guarantee from third parties.

e.     The nature of any assets held either as collateral or by third parties that, upon the occurrence of any triggering event or condition under the guarantee, the guarantor can obtain and liquidate to recover all or a portion of the amounts paid under the guarantee.

f.     If estimable, the approximate extent to which the proceeds from liquidation of assets held either as collateral or by third parties would be expected to cover the maximum potential amount of future payments under the guarantee.

Warrants

3.45 A warrant is an instrument giving its owner the right, but generally not the obligation, to purchase shares in an issuer at a predefined price, within a specified time period. Unlike a call option (which may exist between two parties unrelated to the issuer of the shares), the warrant exists solely between the issuer (that is, the entity in which additional shares will be issued upon exercise of the warrant) and the owner of the warrant. Warrants can exist either as freestanding contracts or as instruments embedded in convertible debt or convertible preferred equity.

3.46 An assessment to determine if a warrant is a derivative may include consideration of the net settlement criteria in FASB ASC 815-10-15-119, in which one of the parties is required to deliver an asset of the type described in FASB ASC 815-10-15-100, but that asset should be readily convertible to cash or is itself a derivative instrument. FASB ASC 815-10-15-131 states that shares of stock in a publicly traded company to be received upon the exercise of a stock purchase warrant do not meet the characteristic of being readily convertible to cash if both of the following conditions exist: (a) the stock purchase warrant is issued by an entity for only its own stock (or stock of its consolidated subsidiaries) and (b) the sale or transfer of the issued shares is restricted (other than in connection with being pledged as collateral) for a period of 32 days or more from the date the stock purchase warrant is exercised. In contrast, FASB ASC 815-10-15-132 states that restrictions imposed by a stock purchase warrant on the sale or transfer of shares of stock that are received from the exercise of that warrant issued by an entity for other than its own stock (whether those restrictions are for more or less than 32 days) do not affect the determination of whether those shares are readily convertible to cash. The accounting for restricted stock to be received upon exercise of a stock purchase warrant should not be analogized to any other type of contract. Refer to paragraphs 133–138 of FASB ASC 815-10-15 for further guidance on when to consider a warrant a derivative and hence trigger FASB ASC 815 disclosure requirements.

Loan Commitments

3.47 Certain investment companies acquire interests in bank lending facilities, including interests in lines of credit and other commitments to lend. Loan commitments are generally defined as written agreements, signed by the borrower and lender, detailing terms and conditions under which a loan of up to a specified amount will be made. The commitment has an expiration date and typically a fee will be paid for agreeing to make the commitment. A commitment can be irrevocable or, in many instances, conditioned on the maintenance by the borrower of satisfactory financial standing and absence of default in other covenants. Lines of credit are often less detailed than a formal loan commitment, and are often letter expressions of willingness to lend up to a certain amount over a specified time frame, usually one year. Many lines of credit are cancellable if the borrower’s financial condition deteriorates; others are subject to cancellation at the bank’s option.

3.48 Loan commitments are typically regarded by financial institutions as off-balance-sheet financial instruments and in accordance with FASB ASC 815-10-15-13 are not within the scope of FASB ASC 815 if specified criteria are met.

Standby Commitments

3.49 A standby commitment is an optional delivery forward placement commitment contract. On the sale of a standby commitment, an investment company is contractually bound to accept future delivery of a security at a guaranteed price or fixed yield on the exercise of an option held by the other party to the agreement. In effect, the investment company sells a put option and receives a fee for its commitment to buy the security. The investment company bears the risk of loss if interest rates rise, causing the fair value of the security at the delivery date to be less than the exercise (strike) price of the option less the fee received.⁸

Commodity and Financial Futures Contracts

3.50 Commodity and financial futures contracts are traded on various exchanges and are thus distinguished from forward contracts, which are entered into privately by the parties. A commodity futures contract is a firm commitment to buy or sell a specified quantity of a specified grade of a specified commodity or, for financial futures contracts (including index futures contracts), a standardized amount of a deliverable grade security (or a basket⁹ for index futures) at a specified price and specified future date unless the contract is closed before the delivery date. For futures contracts, the date is a specified delivery month, and the contract is typically settled by executing an offsetting futures contract before or during the delivery month.

3.51 The quantity and quality provisions of futures contracts are standardized. For example, the unit of trading for cotton futures contracts traded on ICE Futures U.S. (formerly the New York Board of Trade) is 50,000 pounds, and every Treasury bill futures contract traded on the International Money Market of the Chicago Mercantile Exchange is for $1 million notional par value.

3.52 Although a confirmation of the trade is submitted showing the pertinent price, quantity, and commodity data, no amount is usually entered in the general ledger. The ledger reflects only the margin deposit and the daily mark to market for variation margin. Details of open contracts are in memorandum format. Variation margin normally is settled in cash with the broker each morning for the amount of the previous day’s mark to market.

3.53 To initiate a futures contract, the investor is required to make an initial margin deposit in an amount established by the various exchanges. This amount varies according to the commodity or security, the prevailing price, whether the investor is speculating or hedging, and market conditions. The initial margin may often be deposited in Treasury bills. In those cases, the restriction of the ability to trade the Treasury bills should be disclosed in the fund’s schedule of investments. Brokers sometimes require margins in excess of those set by the exchanges.

3.54 An investment company may deposit initial margin on futures contracts directly with futures commission merchants (FCMs) that are registered under the Commodity Exchange Act and that are not affiliated with the investment company. A registered investment company is generally not permitted to deposit initial margin deposits on futures contracts in three-party special segregated custody accounts. Cash or securities deposited to meet margin requirements should be identified as margin deposits on the investment company’s records. Alternatively, the investment company may arrange to put up performance bonds with FCMs.

Forward Contracts

3.55 A forward contract is a legal contract between two parties to purchase and sell a specified quantity of a financial instrument or commodity at a price specified now, with delivery and settlement at a specified future date. Forward contracts are similar to futures contracts, except that they are not traded on an exchange. Their terms are not standardized, and they can be terminated only by agreement of both parties to the forward contract. If a forward contract is held until expiration, settlement by delivery is required. Most forwards are settled in cash. Typically, they do not settle on a daily basis by margin settlement as do futures contracts, although contracts may require collateral to be deposited under certain conditions.

Forward Exchange Contracts

3.56 As defined by the FASB ASC glossary, a forward exchange contract is an agreement between two parties to exchange different currencies at a specified exchange rate at an agreed-upon future date.

3.57 Although these contracts can be speculative in nature, a fund typically enters a forward exchange contract to hedge overall portfolio currency risk or settle foreign security transactions. If the purpose of the contract is to hedge portfolio risk, the contract is typically closed by entering into an offsetting contract before the settlement date. In this way, on the settlement date the fund is only obligated to deliver or purchase the net amount of foreign currency involved.

Interest Rate, Currency, Credit, and Equity Swaps and Swaptions

3.58 Many variations of swaps exist. Swaps can be linked to any number of underlying instruments and indexes, and swap terms can vary greatly. The trade date is the date of the commitment to enter into the swap. The effective date is the date on which the parties begin calculating accrued obligations, such as fixed and floating interest payment obligations on an interest rate swap. The termination date (often called maturity date) is the date on which obligations no longer accrue and the final payment occurs. The term of a transaction lasts from the effective date to the termination date.

3.59 Interest rate swaps represent an agreement between counterparties to exchange cash flows based on the difference between two interest rates applied to a notional principal amount for a specified period. The most common kind of interest rate swap involves the exchange of fixed-rate cash flows for variable-rate cash flows. Interest rate swaps do not involve the exchange of principal between the parties. Interest is paid or received periodically. Swaps range in maturities, usually 1 to 30 years. Market risk and credit risk are two important risks associated with swaps. Credit risk is often minimized by requiring the counterparty to post collateral if any indication of credit risk exists or if the fair value of the swap changes so that a party to the swap becomes significantly “in the money”, or by engaging in swaps only with highly rated counterparties. See discussion of centrally cleared swaps beginning at paragraph 3.65. Market risk requires a careful understanding of the effects on the swap’s fair value of changing market conditions. Both risks require close monitoring. Swaps may be structured so that the notional principal amount is adjusted up or down during the term of the swap. Floating rate reset periods vary, ranging from daily to yearly.

3.60 A currency swap is an agreement between two parties to exchange two different currencies with an agreement to reverse the exchange at a later date at specified exchange rates. The exchange of currencies at the inception date of the contract takes place at the current spot rate. The re-exchange at maturity may take place at the same exchange rate, a specified rate, or the then current spot rate. Interest payments, if applicable, are made between the parties based on interest rates available in the two currencies at the inception of the contract. The term of currency swap contracts may extend for many years. Currency swaps are usually negotiated with commercial and investment banks. Contracts are subject to the risk of default by the counterparty and, depending on their terms, may be subject to exchange rate risk. Some currency swaps may provide only for exchanging interest cash flows, not principal cash flows.

3.61 Some funds may enter into equity swaps to manage their exposure to the equity markets. In an equity swap, cash flows are exchanged based on a commitment by one party to pay interest in exchange for a market-linked return based on a notional amount. The market-linked return may include, among other things, the total return of a security, a custom basket of securities, or an index. These agreements involve elements of credit and market risk. Risks include the possibility that no liquid market exists for these obligations, the counterparty may default on its obligation, or unfavorable changes may exist in the security or index underlying the swap.

3.62 Many funds enter into credit derivatives, including credit default swaps, credit spread options, and credit index products. The FASB ASC glossary defines a credit derivative as a derivative instrument for which (a) one or more underlyings are related to the credit risk of a specific entity (or group of entities) or, alternatively, an index based on the credit risk of a group of entities, and (b) the derivative exposes the seller to potential loss from credit-risk-related events specified in the contract.

3.63 Credit derivatives related to the credit risk of a specific entity are often referred to as single-name credit derivatives.

3.64 A swaption includes any option that gives the buyer the right, but not the obligation, to enter into a swap on a future date. It also includes any option that allows an existing swap to be terminated or extended by one of the counterparties. These structures are also called cancelable, callable, or putable swaps. Swaptions can be American, exercisable at any point during the option term, or European, exercisable only on the last day of the option term. Swaptions that establish swaps when exercised may be puts or calls. In both cases, the fixed rate that will be exchanged is established when the swaption is purchased. The term of the swap is also specified. If a call interest rate swaption is exercised, the option holder will enter into a swap to receive the fixed rate and pay a floating rate in exchange. The exercise of a put would entitle the option holder to pay a fixed rate and receive a floating rate. Calls become more valuable when the underlying securities’ prices rise and rates fall. The option holder will exercise a call swaption when rates have fallen from the strike level. The put swaption will be exercised when market rates rise above the fixed rate that the option holder can pay (that is, prices have fallen).

Centrally Cleared Swaps

3.65 In July 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) was signed into law. Title VII of the Dodd-Frank Act established a comprehensive new regulatory framework for swaps and security-based swaps. One of Title VII’s broad objectives is improved over-the-counter (OTC) derivatives market transparency, which is intended to be achieved through a variety of new requirements enacted through the U.S. Commodity Futures Trading Commission (CFTC) and SEC rules.¹⁰ These requirements include, among other items, the central clearing of eligible OTC derivatives (including most swap agreements). Central clearing requires a central clearing party (CCP, also referred to as a derivatives clearing organization) that functions as an intermediary between the buyer and seller. Two distinct contracts are formed, one between the CCP and the buyer and one between the CCP and the seller. This method is in contrast to the bilateral trading model that has historically been used in the OTC derivatives market, whereby the buyer and seller directly enter into the OTC derivative contract with no intermediary. A multiphase implementation of the central clearing requirement occurred during 2013 for most interest rate swaps and credit default swaps regulated by the CFTC.

3.66 The central clearing mandate intends to reduce counterparty default risk by incorporating a CCP margin reserve fund that guarantees the creditworthiness of both counterparties. The buyer and seller contribute the required margin, through their respective clearing members, to the CCP’s guarantee fund. These margin requirements include an “initial” margin requirement and subsequent “variation” margin requirements. The initial margin requirement is paid to the CCP when the centrally cleared swap contract is executed. This initial margin, typically in the form of cash or qualifying highly liquid, high-quality short-term securities, is held by the CCP in a default fund to be used in the event of default by a counterparty. Following the initiation of the contract, on a daily basis, the CCP determines a new derivative contract “value.” This value is based primarily on the derivative contract’s prevailing market price and, if deemed appropriate by the CCP or a clearing member, may also include an additional component to mitigate any nonpayment or other risks. This incremental daily change in the derivative contract’s “value” represents a net gain for one counterparty and a net loss for the other counterparty. The value of the daily net loss represents the “variation” margin for that given day, which is settled daily by a cash transfer from the counterparty, who incurred the net loss, via the clearing member to the CCP.¹¹

3.67 The following illustration explains the differences between the bilateral model and the central clearing model:

3.68 The following illustration explains the trade flow in the central clearing model:

3.69 Several accounting and reporting considerations arise in conjunction with the adoption and implementation of the central clearing requirements. Readers should consider all applicable provisions of the Dodd-Frank Act, Title VII and related rules of the CFTC and SEC.

Structured Notes or Indexed Securities

3.70 A structured note, as defined by the FASB ASC glossary, is a debt instrument whose cash flows are linked to the movement in one or more indexes, interest rates, foreign exchange rates, commodities prices, prepayment rates, or other market variables. Structured notes are issued by U.S. government sponsored enterprises, multilateral development banks, municipalities, and private entities and can be either short-term or long-term. The notes typically contain embedded (but not separable or detachable) forward components or option components, such as caps, calls, and floors. Contractual cash flows for principal, interest, or both can vary in amount and timing throughout the life of the note based on nontraditional indexes or nontraditional uses of traditional interest rates or indexes.

3.71 Additionally, structured notes are sometimes called indexed securities. These packaged securities have some similar characteristics to a plain debt instrument, such as commercial paper, medium-term notes, or CDs. Instead of paying a fixed interest rate over time and repaying par at maturity, structured notes index the coupon, principal, or both to virtually anything with a trading market. The indexing may be to currencies, interest rate spreads, stock market indexes, or the price of a security or commodity completely unrelated to the transaction. For example, from the standpoint of the holder, many convertible bonds are considered, for accounting purposes, to represent a form of structured note.

3.72 Although structured notes economically represent a debt instrument with an embedded derivative, FASB ASC 815-15-25-1 discusses that embedded derivatives are only required to be separated from their host contract and accounted for as a derivative instrument if, among other things, the instrument is not remeasured at fair value under otherwise applicable generally accepted accounting principles with changes in fair value reported in earnings as they occur.

3.73 Because investment companies report all their investments at fair value with changes in fair value reported in earnings, derivatives embedded within structured notes owned need not be separated from their host contracts and separately reported.

Short Positions

3.74 A seller may make short sales against the box or short sales not against the box. In a short sale against the box, the seller borrows a security identical to one owned by the seller and then sells the borrowed security short. The seller is required to hold securities equivalent in-kind and amount to the shorted security while the against the box short sale is outstanding. The seller incurs transaction costs and forgoes the potential for capital appreciation on the shorted security.

3.75 In a short sale that is not against the box, the seller sells a security that it does not own, in anticipation of a decline in the market value of that security. To settle the short sale, the seller must borrow an equivalent security to make delivery to the buyer. The seller replaces the borrowed security by purchasing it at the market price at the time of replacement. The seller runs the risk that it may not be possible to liquidate or close out the short sale at a particular time or at an acceptable price. To the extent that the seller invests the short sale proceeds in other securities, the seller is subject to the risks of the securities purchased with the proceeds in addition to the risks of the securities sold short. Until the borrowed security is replaced, the seller is required to repay to the lender of the security any dividends or interest which accrue. The seller incurs transaction costs and may be required to pay a premium, both of which increase the cost of the short sale. The seller will incur a loss if the price of the security increases between the date of the short sale and the date on which the seller replaces the borrowed security; this loss may be unlimited. Alternatively, the seller will realize a gain if the price of the security declines between those dates. The amount of any gain will be decreased (and the amount of any loss increased) by the amount of the premium, dividends, or interest the seller may be required to pay in connection with a short sale, and transaction costs. The overall benefit to the seller will depend on how the short sale performs relative to the market price of the securities purchased with the proceeds from the short sale.

3.76 A short sale creates a senior security for registered investment companies that is subject to the limitation of Section 18 of the 1940 Act. To comply with the provisions of Section 18, a registered investment company that sells securities short must establish a segregated account to account for cash or cash equivalents equal in fair value to the securities sold short or equivalent securities already owned if the sale is against the box, as discussed in the section titled “Accounting for Segregated Accounts” in chapter 2, “Investment Accounts.”¹²

Mortgage Dollar Rolls

3.77 Mortgage dollar rolls (MDRs) involve selling mortgage securities and simultaneously agreeing to purchase mortgage securities on a later date at a set price from the same counterparty.¹³ Dollar rolls differ from regular reverse repo agreements in that the securities sold and repurchased, which are usually of the same issuer, are represented by different certificates; and are collateralized by similar, but not identical, mortgage pools (for example, single-family residential mortgages with the same coupon rate and contractual term to maturity, such as 15 to 30 years). Additionally, the securities returned to close an MDR need not have identical principal amounts from the securities initially sold, but must be within the recognized standards for “good delivery” for trading in MBSs. The most common kinds of dollar rolls are fixed-coupon and yield-maintenance arrangements.

3.78 The investment company and the counterparty may decide to extend the contract and not return the securities involved in the roll. The contract may be extended in this manner over a number of periods with the agreement of both counterparties.

3.79 An MDR can also be executed entirely in the to-be-announced market when the investment company makes a forward commitment to purchase a security, and instead of accepting delivery, the position is offset by a sale of the security with a simultaneous agreement to repurchase in the future.

3.80 Compensation to the investment company for the risks involved in an MDR transaction is in the form of either a fee or a reduction in the repurchase price of the security, referred to as the drop.

3.81 The appropriate accounting treatment for an MDR transaction should be based on FASB ASC 860.