TALF funds aren’t making any magic this time around

After raising billions of dollars in the hope of bumper returns in a low-yield environment, TALF 2.0 fund managers may strike out when it comes to achieving the kind of double-digit returns of between 20% to 40% produced by circa 2008 TALF funds.

TALF fund managers said they are holding off on investing because credit spreads tightened dramatically for the asset-backed securities money managers put up as collateral to receive loans under the Federal Reserve Bank's Term Asset-Backed Securities Loan Facility, which was announced in March and went live in mid-June.

Many TALF funds were raised in relatively quick order during the early part of the second quarter, said Alice Lee, London-based director, investments and head of securitized credit manager research for investment consultant Willis Towers Watson PLC, in an email.

However, by the time the first TALF loan was issued in late June, Ms. Lee said "spreads in new issue AAA ABS tightened by more than 70% from levels seen at the end of March," noting that AAA prime auto ABS bonds traded at 60 basis points over the 2-year U.S. dollar swap rate at the end of June compared to 260 basis points at the end of March.

New issuances of securitized assets have been few and were "oversubscribed, which has led to tighter spreads and lower expected returns," Ms. Lee said, adding "as such, capital deployment (by TALF managers) has been slow so far."

The problem with tightening spreads in securitized credit assets for TALF managers is the loss of potential upside returns as asset prices rise and yield falls, said Christopher D. Long, founder, chairman and CEO of credit manager Palmer Square Capital Management LLC, Mission Woods, Kan.

"In addition, as all-in yields tighten below the TALF financing rates, it doesn't make sense to buy more assets using the leverage provided by the TALF program," Mr. Long said.

"It turned out that the Fed was brilliant in that by just announcing the TALF program, it became a backstop for spread levels and led the market to behave more normally as spreads narrowed from really wide spreads," Mr. Long said. Palmer Square Capital manages $12.1 billion, including a new TALF fund.

Sources estimated the universe of TALF managers likely will manage $2.5 billion to $4 billion in their funds, although most money managers contacted declined to comment on their TALF strategies.

Among the institutionally oriented money managers that have launched TALF funds but declined to comment are: AllianceBernstein LP., BlackRock Inc., Hildene Capital Management LLC, Invesco Ltd., Loomis Sayles & Co. LP., MacKay Shields LLC, Morgan Stanley Investment Management, TCW Group Inc. and Varadero Capital LP.

Demand for TALF investments from institutional investors has been high, leaving managers with a lot of money on hand or available through capital calls to put to work within the three years before loans must be repaid in a very tough investment environment, observers said.

"To plan sponsors, in this environment, TALF investments look pretty good in relation to their risk tolerance given that TALF managers are buying AAA-rated fixed income with good financing terms. TALF is like a shiny object in a world lacking opportunity for yield," said Palmer Square's Mr. Long.

Mr. Long said demand for Palmer Square's new TALF fund "was very high" and the firm stopped accepting assets after the fund's second close and created a waiting list. Mr. Long declined to provide the size of the fund.

In May and June, Pensions & Investments reported asset owners invested or committed a total of $972 million to TALF strategies.

Among the largest investments were commitments up to $250 million each by the $51.2 billion Teachers' Retirement System of the State of Illinois, Springfield, and the $74.9 billion Massachusetts Pension Reserves Investment Management Board, Boston.

In May, MassPRIM committed to a separately managed TALF account run by Loomis Sayles.

Illinois TRS chose not to directly invest in a TALF fund and instead gave existing manager Pacific Investment Management Co. LLC discretion in April "to buy direct TALF-eligible securities ... but only if the opportunity presented itself" in a separately managed distressed situation account, said Scottie D. Bevill, senior investment officer for global fixed income, in an email.

"This was a less expensive option for TRS and there were still too many unknowns in April. As soon as the Fed announced further (relief) programs, including the purchase of corporate bonds, spreads collapsed ... outside of legacy (CMBS)," Mr. Bevill said.

Market conditions have put some TALF managers into an investment holding pattern.

Sun Life Capital Management (U.S.) LLC, New York, launched its TALF fund on June 17 after capping fundraising from institutional investors at $550 million. Demand for the fund was high and was two times oversubscribed, the firm said.

"Credit spreads have tightened significantly since the Fed's announcement of TALF in mid-March. We are closely following market dynamics but are currently holding off investing capital until anticipated returns meet our expectations," the statement said.

The firm noted that its TALF strategy that was launched in 2009 had an annual internal rate of return of 21.5%. SLC Management (U.S.) and its Canadian affiliate manage a total of $180 billion.

Voya Investment Management raised about $500 million for its new TALF 2.0 fund through "robust" demand, said David S. Goodson, an Atlanta-based managing director and head of securitized investments, in an email.

When it comes to investing these assets, the Voya team found that "with spreads tightening so rapidly ahead of the launch of the (TALF) program, building a perfectly sculpted model portfolio with assets across all the sectors became an impossibility," Mr. Goodson said, adding that the tightening "effectively reduced the size and scope of the opportunity set."

He said there are opportunities to be found in careful security selection, especially in commercial mortgage-backed securities because CMBS is the one securitized asset class that TALF limits assets to those purchased in secondary markets "so we are not contingent on new issuance, which has been very limited or non-existent in sectors like ABS and (collateralized loan obligations)."

Voya Investments manages a total of $230 billion.

Given the potential for limited capacity, Baltimore-based T. Rowe Price Group Inc. set up its TALF fund as a closed-end private equity fund and only offered participation to the firm's own fixed-income mutual funds and existing separate account clients, said Rudy Pimentel, vice president and head of fixed-income product management.

Even with a limited number of invited investors, Mr. Pimentel said demand exceeded the fund's $250 million cap "by a wide margin" so capital commitments were set at $125 million and the remaining $125 million was set aside for the firm's mutual funds.

T. Rowe Price also has held off calling capital or making investments through the fund, Mr. Pimentel said, noting that "the speed with which securitized credit market spreads have recovered has made use of the Fed's TALF 2.0 facility — the leveraging of investments — less compelling."

"Our team of analysts, traders and portfolio managers stand ready to deploy capital if and when opportunities arise between now and the end of the year when the Fed's TALF 2.0 facility stops accepting loan requests," he said.

T. Rowe Price manages $1.22 trillion.

Willis Towers Watson's Ms. Lee said Fed's extension of the TALF loan window to Dec. 31 from Sept. 30 gives "TALF funds a better chance of ramping up their portfolios. We expect there to be a reasonable chance of a bout of market volatility in the fourth quarter, which could create an attractive entry point."