Fair value hierarchy

ASC 820 (and IFRS 13 for international funds) establishes a three-level hierarchy for fair value measurements. Where your positions fall in this hierarchy affects disclosure requirements, auditor scrutiny, and LP perception.

Understanding the hierarchy is not about gaming classification. It is about accurately representing how much market-observable support exists for your marks.

Level 1: quoted prices in active markets

Level 1 applies when you have quoted prices for identical instruments in active markets. The price you see is the price you use. No adjustments, no judgment.

Criteria for Level 1 classification

Identical instrument: The quoted price must be for the exact CUSIP or security you hold
Active market: Transactions occur with sufficient frequency and volume to provide pricing information on an ongoing basis
Quoted price: The price is available from an exchange or an interdealer market

Where you’ll see Level 1 in ABF

Agency RMBS (Fannie, Freddie, Ginnie pass-throughs and CMOs)
Liquid benchmark corporate bonds used as hedges
Treasury securities in reserve accounts
Some large-issue, frequently-traded term ABS senior tranches

Why Level 1 is rare for most ABF positions

Most ABF positions are bespoke. Even if you own a tranche of a widely-traded term ABS deal, your specific CUSIP may not trade with enough frequency to qualify as Level 1. A deal may have traded last week, but if your particular tranche has not traded in months, it does not qualify.

The test is not whether the asset class is liquid. The test is whether your exact position has observable quoted prices.

Level 2: observable inputs

Level 2 applies when you do not have a quoted price for the identical instrument, but you have observable inputs that can be used to value it. The valuation is anchored to market data, even if some adjustment or modeling is required.

Observable inputs that support Level 2 classification

Input Type	Description
Quoted prices for similar instruments	Comparable deals, adjacent tranches, same shelf
Executable dealer quotes	Bids that represent actual willingness to transact
Interest rates and credit spreads	Observable yield curves and spread indices
Pricing service valuations	When based on actual transaction data, not just models
TRACE-reported trades	Actual secondary market transactions in comparable paper

Where you’ll see Level 2 in ABF

Term ABS tranches with dealer marks or TRACE-reported trades
Positions where a pricing service provides a mark based on observable comparables
Instruments that can be reliably benchmarked to liquid reference indices
Senior tranches of established ABS shelves with regular secondary trading

The judgment call: executable vs. indicative quotes

A dealer quote is Level 2 if it represents an executable bid. The dealer is willing to transact at that price. This is observable market data.

A dealer’s “color” (their estimate of where something might trade if a buyer appeared) is closer to Level 3. It represents the dealer’s judgment, not an observable market price.

Quote Type	Level Classification	Why
Executable bid	Level 2	Represents actual market willingness
Indicative bid (with context)	Level 2 or 3	Depends on how the dealer derived it
Color / opinion	Level 3	Dealer’s model output, not market data
BWIC result	Level 2	Actual executed transaction

If you are relying on dealer quotes for Level 2 classification, document whether the quotes are executable and whether the dealer has any positions in the paper.

Level 3: unobservable inputs

Level 3 applies when significant inputs to the valuation are unobservable. You are using internal assumptions, models, and judgment to derive fair value.

When Level 3 applies

No secondary trading exists for your position
Available quotes are indicative only or stale
The position has bespoke structural features that differ from any comparable
Market conditions are dislocated (quotes may exist but do not reflect orderly transactions)
You are running a DCF model with your own default, prepayment, and severity assumptions

Where you’ll see Level 3 in ABF

Warehouse residuals and first-loss positions
Private placement tranches with no secondary trading
Participations in loan pools
Subordinate tranches of bespoke securitizations
Any position valued primarily through internal modeling

Disclosure requirements for Level 3

Level 3 positions require more extensive disclosure than Level 1 or Level 2:

Disclosure Requirement	What You Must Provide
Quantitative sensitivity analysis	How the mark changes with different assumptions
Reconciliation	Beginning-to-ending balance roll-forward
Transfers	Positions that moved into or out of Level 3 during the period
Valuation process	Description of methodology and governance
Significant unobservable inputs	The specific assumptions driving the valuation

LP and auditor perception

LPs get nervous when Level 3 is too large a percentage of your portfolio. It signals that marks are manager-driven rather than market-driven. But for ABF funds, high Level 3 concentration is normal.

Typical ABF fund composition: 10-20% Level 2, 80-90% Level 3.

The key is not avoiding Level 3. The key is having a rigorous, well-documented process that produces defensible marks.

When Level 2 becomes Level 3

The classification is not always obvious, and positions can shift between levels as market conditions change.

Example: term ABS tranche classification

Consider a term ABS tranche with these characteristics:

You bought it in the primary market at par six months ago
There has been no secondary trading in your CUSIP
A dealer provides a monthly quote of 99.5
You have no way to verify whether that quote is based on actual market transactions or the dealer’s model

Is this Level 2 or Level 3?

It depends on whether the dealer quote is truly based on observable market activity. If the dealer is just running their own model with assumptions you cannot verify, it is Level 3 dressed up as Level 2.

Questions to ask when classifying

Is the quote executable? Would the dealer actually buy at this price?
What is the basis? Is it derived from recent transactions or from models?
How comparable are the comparables? Is the spread adjustment more significant than the observed data?
What has changed? Has trading dried up since your last classification?

Classification documentation

Document your classification rationale at the position level. The documentation should be specific and auditable.

Classification Approach	Defensibility
”Classified as Level 2 based on monthly executable dealer bids with bid-ask spreads of 25-50 bps”	Defensible
”Classified as Level 2 because we got a quote”	Not defensible
”Classified as Level 2 based on TRACE-reported trades in similar tranches within the past 30 days, adjusted by 15 bps for structural differences”	Defensible
”Classified as Level 2 because pricing service provided a mark”	Not defensible without knowing the pricing service methodology

Classification changes over time

Positions can move between levels as market conditions evolve:

Level 2 to Level 3: Market liquidity dries up, dealer quotes become stale, comparable transactions disappear
Level 3 to Level 2: Secondary trading picks up, pricing services establish coverage, dealer quotes become executable

Transfer disclosure

When a position transfers between levels, you must disclose:

The position(s) that transferred
The reason for the transfer
The direction (into or out of Level 3)
The impact on your fair value hierarchy disclosure

Frequent transfers can signal instability in your valuation approach. Aim for consistent classification unless market conditions genuinely change.

Best practices for hierarchy management

At the position level

Classify each position individually, not by asset class
Document the specific inputs supporting your classification
Review classifications quarterly, not just at audit
Keep records of the market data that supported Level 2 classification

At the portfolio level

Track Level 3 concentration over time
Identify positions near the Level 2/3 boundary
Prepare for auditor questions about classification judgments
Anticipate LP concerns about Level 3 concentration and be ready to explain your process

Common mistakes

Mistake	Why It Matters
Classifying by asset class instead of by position	Each CUSIP must be evaluated individually
Treating indicative quotes as Level 2	Unexecutable quotes do not provide observable market prices
Failing to reclassify when markets change	Classifications must reflect current conditions
Over-relying on pricing services without understanding methodology	”Evaluated prices” may be Level 3 inputs from a third party