It's been tough times for the mutual fund fee securitization sector, especially in light of volatility in the equity markets and investor uneasiness in the asset class, sources say.

However, dramatic movement in fund net asset values (NAVs) is likely to spawn a next generation of these deals, with structural enhancements aiming to mitigate stock market volatility risk from the fee-backed transactions.

Some managers have talked about offsetting declines in the fee cashflows by structuring a hedge account into the deals, which would buy and sell options in a stock market index, such as the S&P 500, to appreciate in value during an adverse market.

"There's always been a desire to try to figure a way to hedge against some of the market risk," said John Schiavetta, a managing director at Fitch. "The challenge is that this would typically introduce a degree of active management."

Of course, active management introduces a whole new set of risks, such as exposure to the manager's rating [and solvency].

Managers have also been talking about somehow incorporating a dollar-cost-averaging mechanism into the deals. Dollar-cost-averaging is a simple investment theory whereby small, continual investments, throughout all cycles of a market, mitigate market risk.

Not with my dollars...

According to Moody's Investors Service, the rating agency rated $1.1 billion worth of 12b-1 deals in 2000. That tally does not include deals from Putnam Lovell, which also structures deals backed by variable annuity fees.

So far this year, just one mutual fund fee-backed deal has come to market, a $200 million transaction from Constellation Financial Management in January, led by Bear Stearns. According to sources familiar with the deal, it was originally planned for December of last year.

"People just wanted to take a breather after what happened in the equity markets last year," said a banker working in the sector. "I guess it's been a little difficult for an investor to go into a credit committee with an asset-backed bond that's backed by equity market investment risk."

Although the sector has been stagnant, pros expect it to show some life later this year, if market conditions become more suitable.

"As the year rolls along, the originators and purchasers of these fees are going to have larger and larger portfolios," said Michael O'Connor, analyst at Moody's. "I would guess that if the volatility eases up, and people start to have a more positive view of the market, you're likely to see securitizations."

Volatility in the 12b-1 deals

One the hardest sells on the fund fee-backed bonds is that their ratings are more volatile than ratings on most corporate bonds, which is why the issuers are apt to structure some of the market risk out of the deal, Moody's O'Connor said.

Interestingly, the underlying assets that support the deals, on average, become more valuable because the stocks or the bonds become more valuable over time. Thus, on average, the credit of the collateral becomes better over time.

"The ratings mean the same thing, but they're more volatile," Moody's O'Connor said. "So they can swing both ways. On average, the assets get better, but the changes you can see are much more pronounced than in a corporate bond."

Separately, several sources reported hearing that Putnam Lovell is not originating new financing contracts, and is moving out of the market when its existing pipeline peters out. However, officials from the bank were not available for comment when ASR learned of this rumor.

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