San Francisco-based Charles Schwab Investment Management, Inc. may have fewer choices when it comes to buying asset-backed bonds for its multi-billion-dollar 2a7 money market funds. The rules of the game - in accordance with the SEC - allow for only short-end, tier-one rated investments. This has kept the investment firm out of the ABS term market. But the company is bullish on asset-backed commercial paper, which makes up between $18 billion and $26 billion - over 40% - of Schwab's total money market investments.

"We have 19 billion right now in asset-backed commercial paper," said Greg Reiter, vice president of taxable research at Schwab.

Reiter said ABCP volume hovers currently at the low end of Schwab's range because of the technicals that have cropped up recently and softened the market. As a hedge against fishy environs, the firm's fund managers have been focusing on buys overseas.

"We've just noticed that the yields in the Libor-based floating CP have been backing down a little bit. We've been buying mostly European stuff: European banks, Yankees and euros."

Schwab manages four retail money market funds totaling approximately $60 billion that have hefty allocations to ABCP. The largest of the funds - dubbed rather obviously The Schwab Money Market Fund - totals $31 billion. The second weighty 2a7 - The Schwab Value Advantage Money Fund - contains $25 billion in net asset value. Two much smaller funds round out the firm's CP allocations: The Schwab Institutional Advantage Money Fund and The Schwab Retirement Money Fund.

Reiter said the investment strategy that best describes Schwab's is buy-and-hold. "Our goal is to earn some yield and be safe," he said.

Reiter said Schwab likes to keep the net asset value of most of its funds at one dollar. So when the portfolio is priced each night, the various money market funds show that value as opposed to some value constantly moving up and down with the market. Whatever remains, he says, is yield.

"These are all retail money market funds," he said. "Money comes in every day; money comes out. If there's an inflow, we have to buy stuff if we want to put it to work. If there's an outflow, we try to sell assets. We try to prepare for the latter by having a little liquidity on the side."

Working under the rules of the SEC, Schwab can only purchase debt that is considered 2a7-eligible. This means that all asset-backed programs bought by the firm must be of tier-one quality - meaning a rating of A-1, P-1, D-1 and/or F-1 by the agencies - and the maturities on the bonds cannot extend longer than 13 months in maturity.

Within these narrow confines, however, Reiter said Schwab is very aggressive. ABCP purchases made for the firm's funds run the gamet in terms of asset class.

"We buy everything you can think of," he said.

Lauren Hill, a senior credit analyst with the firm, said the primary asset classes contained in the Schwab-owned programs are autos, credit cards, trade receivables, corporate and mortgage loans. Yet she also leaves room for the occasional off-the-run purchase.

"Basically, 95% of the programs we own are highly diversified," she said. "We do buy some one-off transactions. There might be a 2a7 money market tranche the issuer issues, where there will be a bunch of term stuff underneath it, but they'll issue a short tranche that we can invest in. We've done quite a few of those."

Hill said that though Schwab has yet to participate, she and her colleagues are looking into some of the newest trends and emerging products entering the market. A recent development among both European and U.S. banks is what some are calling "structured investment vehicles" or "securities arbitrage." Banks buy long-term assets and fund it with short-term commercial paper and a small bit of medium-term notes.

"Typically the majority of them are buying other asset-backed securities, mortgage-backed securities or packaged corporate loans like CLOs or CBOs, and then offering them as CP programs."

A "leveraged investment conduit," another emerging program Schwab has been watching closely, occurs when an issuer will lever 10 to 20 times the amount of CP they have outstanding in terms of buying, and then fund it with CP. These programs don't have 100% liquidity, which is atypical, Hill said.

Typically these structures are funded by medium-term notes, and have crept up of late in both the euro and the U.S. CP/MTN markets.

"The credit risk is so high that you're less concerned about the market value of the assets," she said.

This seesawing between credit risk and liquidity is a fact of life for investors in the ABCP market.

"It's typically a tradeoff between better assets and better support," Reiter said. - SK

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