Waiter, There's Some TALF in My Mutual Fund

• By Harry Milling
• On 7:00 am EDT, Thursday October 22, 2009

Some fund companies think they've found a way to take advantage of the U.S government's efforts to prop up the asset-backed securities market without exposing their investors to undue risk. Are they right? Here's a look at how T. Rowe Price (NasdaqGS:TROW - News) is doing it.

Private Fund
T. Rowe has set up a private fund that will borrow money on the cheap from the U.S. government's Term Asset-Backed Securities Loan Facility and reinvest it in higher-yielding, but still triple-A rated, commercial mortgage-backed securities. These securities are pools of commercial mortgages that make periodic payments. The private fund will make its first CMBS investment this month.

T. Rowe is hardly alone here, and PIMCO and Franklin Templeton are among the fund companies that have found different ways to make opportunistic investments using TALF. The kicker here is that T. Rowe's mutual funds--both fixed income and equity alike--are now able to gain indirect exposure to TALF by being among the main investors in T. Rowe's private TALF fund.

Tempting Terms
Like any investment, this one is hardly risk-free. Rising default rates in the commercial mortgage-loan market are keeping yields high for CMBS and pressuring prices (which move in the opposite direction of yields). While fears of defaults and downgrades could keep the CMBS market volatile, the low pricing on the highest-quality CMBS tranches creates a lucrative opportunity for T. Rowe's private fund given TALF's terms.

TALF was set up a year ago by the U.S. Treasury and the Federal Reserve Board to encourage investment in CMBS as well as asset-backed securities, which are backed by loans other than real estate, like credit card debt. Investors fled these markets at the height of the credit crisis in 2008 amid concern of widespread defaults on the loans backing the securities.

Under TALF, institutions can get loans at only 100 basis points above LIBOR swap rates in order to buy these securities while yields on even the highest-quality CMBS are several hundred points above LIBOR swap rates. That's partly because of the threat of rising defaults in the future, but, also, the CMBS market struggled from a lack of liquidity throughout the credit crisis. In fact, the "haircut" (effectively a down payment reflecting risk of the security) that T. Rowe must pay on the loan is 15%. That seems like a high hurdle, and near-term volatility may mean the private fund falls short at times, so the investment is hardly without risk.

A Little R&R (Risk & Reward)
But, over the long term, pricing should recover with the economy. Moreover, T. Rowe itself has never blindly relied on outside rating agencies and instead uses its own army of respected analysts to establish creditworthiness. It's comforting that T. Rowe's Susan Troll, a structured finance analyst who is well known for pushing T. Rowe out of subprime mortgages more than a year before the credit crisis, will be a key analyst for the private fund.

Risk to individual investors is tempered further by the fact that individual mutual funds are permitted to have no more than 5% of their assets in TALF-related securities. Of course, this also means that a mutual fund's participation in TALF through the new private fund won't significantly boost overall returns. However, for domestic equity funds, it can't hurt if the U.S. stock market's current rally is cut short.

Some T. Rowe mutual fund investors already have been TALF beneficiaries, as T. Rowe Price New Income (NASDAQ:PRCIX - News) and T. Rowe Price Short-Term Bond (NASDAQ:PRWBX - News) began participating in TALF as individual funds in the third quarter. These two funds had to meet the $10 million investment minimum required by TALF. Because the new private fund will pool investments, individual T. Rowe funds can now participate with much less than $10 million--a primary reason behind the decision to create the private fund.

T. Rowe should be able pull this off without hurting fund investors.

Harry Milling does not own shares in any of the securities mentioned above.

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