There is a growing interest in securitizing 12b-1 fee receivables. This type of securitization pools the fee receivables from numerous funds and fund families in a segregated bankruptcy-remote trust. The trust then issues securities backed by such fees. In general, the volatility, the magnitude, and the timing of the cash flows from the fee collections determine the value and the risks associated with these securities. These risks are usually quantified using deterministic and probabilistic models such as a discounted cash flow approach, Monte Carlo simulation and ratio analyses.
Today, there are more than 8,000 mutual funds in existence in the US, of which about 6% has been involved in secuitization. More than 40% of the funds currently use the 12b-1 fee arrangement to cover at least part of their distribution-related expenses. B-share plans have enjoyed a tremendous growth in recent years.
In terms of net asset value (NAV) outstanding, B-shares account for about 9% of all mutual fund shares. Although the mutual fund industry is mature, the fee securitization is still a developing asset class. Aside from over 25 term transactions issued to date in the ABS market, a few asset-backed commercial paper programs have also invested in fund-fee receivables. This asset class is very similar to several other structured transactions, such as the securitization of mortality and expense fees for variable rate annuities and variable annuity risk transfer transactions. A number of the transactions include funds from outside of the US, particularly Canada.
Securitization of mutual fund fees was developed as an alternative funding source for expenses associated with the marketing and distribution of the funds shares. Most of these expenses, including the broker's sales commissions, are incurred when the funds shares are sold. Rather than charging the investor the full cost at that time, the mutual fund industry developed a class of shares known as the B-class shares that pay the cost of distribution over a prescribed number of years. In other words, the distribution expenses usually occur before and at the time of initial sales, but the fees paid by the B-class investors to cover these expenses are normally recouped over many years. This allows the investors to be fully invested at the time of purchase. The fees paid by the B-class shareholders constitute the collateral for the mutual fund fee securitizations. They include spread loads (SL), commonly known as 12b-1 fees, and contingent deferred sales loads (CDSL), or back-end loads. Shareholder servicing fees (SSF) may be charged to all shareholders to cover ongoing servicing expenses. SSF on a limited basis have been included in some of the transactions. These fees are separate and distinct from the asset management fees that are charged by most mutual funds.
The 12b-1 arrangement allows investors to pay the fees over time and therefore to be fully invested at the time of purchase. Spread loads are limited to 75 basis points per year of the fund's average NAV, with a lifetime cap of 6.25% of the total new gross fund sales, plus interest at the prime rate plus 1% per year. The annual load percentage may be less than 75 basis points, depending on the funds and their board's decision. The collection period is usually limited to a period of six to eight years, which is sufficient to cover the initial distribution expenses. At the end of this period, B-shares typically convert to A-shares that are not subject to distribution expense-related fees.
Contingent deferred sales loads are also known as back-end loads. CDSL is charged when a B-class shareholder redeems shares. It is charged as a percentage of net asset value, typically at the lower of initial cost or the fund's current market value at the time of redemptions. The fund charges CDSL to the B-share investors to recover the distribution expenses, and to prevent any shortfall in the total fee collections. Following the initial purchase of the B-shares, CDSL typically starts at 5% to 6% and declines over time on a sliding scale until it goes down to zero, usually within five to seven years.
There are exemptions to CDSL fees in certain cases. For example, CDSL cannot be charged in the case of retirement-related mandatory withdrawals. In addition, most mutual funds allow automatic monthly withdrawals and transfers between funds within a fund family without incurring any CDSL. Free share redemptions are also not subject to any CDSL. Free shares are created when investors reinvest the fund's distributions back into the fund.
Many risk factors are inherent during the collection of the fee receivables. Factors such as market risk, distribution and reinvestment risks, redemption risk and termination risk may increase the volatility of the cash flow from the 12b-1 and CDSL collections. In particular, the market risk - a decline in the fund's market value due to systematic events - may have an adverse impact on the anticipated cash flow that is needed to pay the security holders. The existence of unsystematic risk, and a possibly high correlation between the market risk and redemptions, may also increase the volatility of the anticipated cash flows from the fee receivables, increasing the default likelihood of the securities. In addition, the type of funds, their risk levels, and the correlation among funds may influence the cash flow volatility.
During favorable market conditions, the securities may be repaid more quickly than expected, thus reducing the transaction's default risk. However, during market declines or periods of poor performance by the funds, the expected cash flow may decline and the volatility of the anticipated cash flows may increase. As a result, this could increase the average life of the asset-backed securities and their default risk.
In general, an increase in any of the following factors will increase the securities' likelihood of default:
*Late redemption on commission shares
*Redemption on free shares
*Fund share aging
*CDSL exemption rate
An increase in any of the following factors will decrease the securities' likelihood of default:
*NAV growth rate
*Early redemption on commission shares