The Emerging Market Bond Fund Redemption
A UK-domiciled open-ended investment company (OEIC) invests in emerging-market local-currency government bonds. Over two weeks, redenomination fears in one country (which represents 12% of the fund) cause a 9% fall in that holding's value. Redemptions spike: investors request 18% of the fund's £300m NAV in a single day. The fund's assets are 85% in bonds that normally settle T+2 but in the affected market now settle T+5, and 15% in cash. The fund's prospectus permits up to 10% of NAV in 'illiquid' assets and allows the ACD to impose a dilution levy or suspend dealing in 'exceptional circumstances'. The fund's price is struck at 12:00 using the previous day's closing prices for the affected market because the local exchange was closed.
1. Assess the pricing and liquidity problems the fund faces and their consequences for continuing versus redeeming investors.
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Pricing problem: The fund is priced at 12:00 using stale previous-day closing prices for a market that has fallen 9% and is closed. The 12% holding is likely overvalued in the NAV. New redeemers would exit at an inflated price, and continuing investors would bear the loss when the market reopens lower - a dilution of those who stay.
Liquidity problem: 18% redemption vs 15% cash and 85% bonds, of which the affected 12% now settles T+5. The fund cannot meet 18% redemptions from cash alone (15% < 18%) and must sell bonds - potentially at distressed prices in a closed/illiquid market. The 10% illiquid cap may be breached if the affected holding becomes illiquid.
Consequences:
- Redeeming investors get a stale, too-high price - they are advantaged at the expense of stayers.
- Continuing investors absorb the dilution and any forced-sale losses.
- Fair treatment (FCA principle) is compromised unless the ACD acts.
2. What tools can the ACD use, and which is most appropriate here?
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Available tools (per prospectus and COLL rules):
- Dilution levy / swing pricing - adjust the price to reflect the cost of selling assets to meet redemptions. This protects continuing investors by making redeemers bear their share of dealing costs. Most appropriate here: the problem is a large one-day outflow against illiquid/stale assets, exactly the dilution scenario swing pricing is designed for.
- Suspend dealing - permitted only in 'exceptional circumstances' where orderly valuation/dealing is impossible. A 9% fall and a closed exchange is serious but suspension is a last resort; it traps all investors and can trigger a run on reopening.
- Fair value pricing / price adjustment - re-price the affected 12% holding to reflect the 9% fall (or a modelled fair value) rather than stale close. This corrects the NAV and is arguably a prerequisite to any levy.
- Side pockets / gating - not standard for a UCITS-style OEIC; gating is more common in hedge funds.
Recommendation: Fair-value the stale holding first, then apply a dilution levy on the redeeming 18% to protect stayers. Reserve suspension for if the market remains closed and valuation becomes impossible. Suspension alone is disproportionate and unfair to investors who want to stay.
3. The affected country is 12% of the fund and is now effectively illiquid. Does this breach the 10% illiquid limit, and what should the ACD do about it?
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Limit test: The prospectus caps illiquid assets at 10% of NAV. The affected holding is 12% - a breach if it is classified as illiquid. The ACD must:
- Confirm classification - is the holding genuinely 'illiquid' (T+5 settlement, closed exchange), or merely temporarily hard to trade? A closed exchange and T+5 settlement strongly suggest illiquidity for valuation/dealing purposes.
- Notify the depositary and, if required, the FCA - a breach of investment limits must be reported and remedied in the investors' best interests, without undue delay.
- Remedy - either reduce the holding below 10% (difficult in a closed market) or, if the breach arose from market events outside the ACD's control (passive breach), document it and take steps to restore compliance as soon as reasonably practicable. Passive breaches from market movements are typically treated differently from active breaches.
- Disclose to investors in line with the prospectus and COLL requirements.
The ACD cannot simply ignore the breach; it must act in investors' interests, document the passive nature, and restore compliance once the market reopens.