Though only showing a little over $3 billion in issuance since its 1996 inception, the distribution-fee finance sector - more commonly referred to as the mutual fund fee or 12b-1 sector - is poised for significant growth, with nearly $1.5 billion still left in the pipeline for this year, according to issuer estimates.
Of the trends sustaining this growth, most significant is a pending change in tax laws regarding the deferral status of B-share fees, which are the securitizable assets of mutual funds.
In 1993, there was a "Tax Advice Referendum" granting the fund complexes the ability to deduct commission expenses, or distribution costs, at the time incurred, for tax purposes.
Subsequently, the Internal Revenue Service has decided to amend the referendum such that the distribution costs are not immediately deductible, said an industry source. The cost will most likely be deductible over the contingent deferred sale load (CDSL) period.
"It's one of the reasons that people haven't securitized in the past, because of the tax benefit of the deferral," said one market source. "If you take the tax deduction up front, your revenue comes in over eight years. There's no tax benefit there."
The proposed effective date for the referendum is June 30, 2000.
Though the growth in the sector seems robust, potentially exceeding 50% when the year is done, the overall penetration of distribution finance into the mutual fund industry is still slight when looking at the potential market.
"The penetration of this technique is growing, but the numbers still aren't going to be earth shattering," said an industry source. "Even if you have $1.5 billion of securities issued this year, that pales in comparison to the $20 billion that companies are going to spend on distribution costs. The market can easily double and you still have low penetration of the technique."
Other Trends
With the recent addition of CIBC (see profile page 14), there are now four firms claiming market share for the distributions-finance sector, the other three being Constellation Financial Management (see profile, ASR 1/17/00), Putnam Lovell Securities (see profile, page 13), and Citibank.
Probably one of the most evident changes in the sector, said members of all of the above, is the expanding investor base. Joseph D'Anna, a managing director at Constellation, says the team is adding up to five new investors per deal.
The most obvious reason for the growing investor base is that the sector is maturing and broadening, and, as a result, moving out of the early adopter stage.
"It's probably at a stage now where you have a decent amount of deals issued at different times that are outstanding, and you have a range of track records, and that is a benefit to the investors in this asset class," said Mike Llodra, a senior vice president at Putnam Lovell.
Said investor Steven Staggs, "The market for mutual fund fees securitizations continues to become more efficient, and as investor receptiveness increases, it's likely that as with all emerging assets classes, we will experience spread compression overtime."
Staggs is a vice-president and team leader in the structured finance group at Lincoln Investment Management.
Global B-Share Growth
As across all ABS sectors, globalization is another factor boosting the distributions-fee financing sector going forward, said Paul Donlin, a managing director at Citibank. Currently, Citibank tops the issuer league table for mutual fund deals, with proceeds in excess of $1.2 billion.
"This is a product that is growing all over the world," Donlin said. "It's technology we're exporting to Europe, to Asia-Pacific, to Canada, to Latin America."
The foreign markets, said Donlin, are increasingly looking for deferred sales charge types of distribution structures.
Via a currency swap, Canadian collateral has already found its way into existing transactions, including a recent deal from Putnam Lovell Securities.
"We have foreign clients as part of our transactions," Citibank's Donlin said. "We purchase assets from foreign distribution sources. That probably is a trend that is accelerating as more and more of our global fund managers are looking to sell B-shares around the world."
The growth in B-share sales seen globally is a direct reflection of what is seen domestically, as the percentage of B-share volume in the U.S. continues to increase quite significantly.
To be clear, this is not so much a new phenomenon: it is more a continual shift in the marketing and sales of these bonds. According to Citibank's figures, the deferred share sales have grown at approximately 31% compound annual rate over the last five years.
The effect is that, as the sales continue to grow, the percentage of deferred sales of B-shares grows, which increases the financial burden on the distributors of the fund complexes.
"That growth obviously has a two-folded impact," Donlin said. "It increases in the size of the potential market and it also give the distributors more of an impetus to securitize because of the financing demands on the balance sheet."
Down the Line
In addition to variable annuities, other asset management-related products with similar structures will likely enter the sector within the next few years, said industry sources.
A candidate for this kind of financing includes the fees associated with wrap funds. Bisys Group is said to be one of a few fund managers looking to securitize the fees.
"I would expect to see [wrap fees] included in either a multi-seller transaction or on an agency basis in the next 12 to 18 months," an industry source predicts.
Other potential products are closed-end funds and offshore mutual funds.
As for now, however, the bonds are mostly backed by 12b-1 fees, with just a minor spike of new product - though the potential market for the distribution fees of variable annuities could be larger than the 12b-1 market.
At press time, word had it Citibank was in the process of closing its fifteenth trust for approximately $110 million, though Citibank's Donlin would not comment. And Putnam Lovell was said to be in the beginning stages of its largest transaction to date.
