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DOI Issues Advisory Opinion on Corporate Bond Downgrades

April 6th, 2016

Article 3 and 4 Pension Funds are allowed to invest in corporate bonds managed through an investment advisor if all of the following requirements are met:

“(1)     The bonds must be rated as investment grade by one of the 2 largest rating services at the time of purchase.

(2)       If subsequently downgraded below investment grade, the bonds must be liquidated from the portfolio within 90 days after being downgraded by the manager.”

40 ILCS 5/1-113.2(14)

Recently, we have seen more than one fund face a situation where one of its corporate bonds is downgraded below investment grade by Moody’s but not S&P.  RDK asked the DOI to weigh in on the effect of a downgrade by only one of the two largest rating agencies.  In response, the DOI has advised its interpretation of the above statute requires the Fund to liquidate the downgraded bond.

Specifically, the DOI opined the fund must liquidate the downgraded bond “even if another rating agency has not (yet) downgraded the bond.”  The DOI went on to state, “When read in its entirety, it is clear Section 1-113.2(14) intends that an article 3 or 4 (sic) is not permitted to hold a corporate bond rated below investment grade.”

Finally, the DOI opined that investment managers/advisors serve in a fiduciary capacity to the fund and must therefore liquate the downgraded bonds immediately even while acknowledging the Statue allows 90 days to liquidate thereby “avoiding a fire sale” in the words of the opinion.  “To do otherwise would be contrary to their fiduciary responsibilities of care, skill, prudence and diligence under the circumstances then prevailing that a prudent man would use.”

While a formal written opinion was requested, due to time constraints the above opinion was issued via email correspondence.  A request has been made to memorialize the DOI opinion in a formal opinion and we will continue to provide any updates as they become available.