Could a Rising PPIP Tide Lift Your Bond Fund Boat?

That said, we wouldn't be surprised to see new closed-end funds launch fairly soon, and we've spoken with several managers who are considering real estate investment trusts further down the line. The asset managers involved and the Treasury Department are quite aware of the operational challenges that make it difficult to include mutual fund investors in PPIP's first outing. Our impression is that the lines of communication between the two camps are quite open, which in our view improves the chances of effective outcomes.

In the Meantime ...
The ripple effect of PPIP and TALF 2.0 could have a meaningful impact on mutual fund investors nonetheless. In addition to the $5 billion mentioned above, and the potential for more asset managers to participate in that aspect of PPIP, there is a second component of PIPP that could inject additional liquidity into the mortgage markets. That second element is designed to facilitate the purchase of troublesome whole loans (which haven't been packaged into securities) from the banks by asset managers. When factoring in both aspects of PPIP and TALF 2.0, the trading and pricing of nongovernment mortgage-backed and asset-backed securities could continue to improve. Prices in the MBS and ABS markets tanked in 2008 as massive sell-offs and the unwinding of leveraged portfolios drove prices lower and lower. As prices fell, more investors needed to sell, sending prices to distressed levels. Finally, many investors headed for the exits and major broker-dealers including Lehman Brothers, Bear Stearns, and Merrill Lynch essentially closed down their fixed-income trading operations. Other major market makers wanted little to do with the situation, and trading virtually stopped.

Trading and pricing have improved in some areas of the ABS and MBS markets in recent months, and as the initial asset managers and the U.S. Treasury step into the breach, mutual fund managers currently holding nongovernment mortgage-backed or asset-backed fare may see prices on some beaten-down holdings begin to rise. In fact, several managers already holding securities similar to those featured in PPIP and TALF 2.0 have commented that they've seen a noticeable bounce in some of those sectors. How much or how fast investors in mutual funds ultimately benefit from better pricing remains to be seen, and large allocations to nonagency or subprime mortgage-backed fare are more the exception than the rule. Yet it is possible that some funds hammered by losses in 2008, such as  Western Asset Core Bond (WATFX) or  Morgan Stanley Institutional Core Plus Fixed Income (MPFIX), may be able to make up some lost ground if PPIP and TALF 2.0 truly take off.

Don't Break Out the Party Hats Quite Yet
Despite the potential ripple effect of PPIP or TALF 2.0, it is a stretch to assume that the mortgage-backed and asset-backed markets will look like they did before everything fell apart. There's much less money floating around than there was then, and the landscape of willing buyers has changed dramatically. Managers who already offloaded substantial stakes of MBS and ABS won't necessarily reap the benefits. The details of both programs still need to be worked out, reflecting Treasury's aim to get the word out sooner rather than later in an attempt to bolster market confidence. We believe that the Treasury has solicited meaningful input from potential participants, and we'd expect to have a clearer picture of PPIP as well as the initial participants' plans in mid-to-late June.

There are a number of other issues clouding the picture as well. The Federal Reserve's recent bank stress tests indicate that a number of banks big and small still need to clean up their balance sheets, which could prompt sales of assets through PPIP. Yet recent mark-to-market rules proposed by the Financial Accounting Standards Board could give those same banks more breathing room to hang on to those securities, which might rain on PPIP's parade. In addition, Congress' legislative efforts to aid homeowners, such as the so-called "safe harbor" bill, could affect the contracts backing some of the securities that asset managers hope to purchase through PPIP. If asset managers get the impression that the government is unwilling or unable to guarantee contracts of mortgage-backed securities or protect asset managers from attempts to claw back some of the profits made through PPIP, we wouldn't be surprised to see managers back away from the program en masse.

It also remains to be seen if PPIP and TALF 2.0 can overcome the effects of the moribund economy, the shattered housing market, and a weakening climate for commercial real estate. Most of the asset managers with whom we've spoken have already priced in pretty dire scenarios for the securities that they hope to purchase when estimating how much they're willing to pay. Some managers are focusing on bonds that they think will offer value even if defaults on the underlying mortgages hit a sickening 97%, with recoveries on those loans in the range of 20-30 cents on the dollar. Once those opportunities are snapped up, it's possible that some swaths of the mortgage-backed market (such as securities backed by commercial mortgages or adjustable-rate subprime residential mortgages) might lag or even experience additional pain.

Stay Tuned
It is too early for us (or anyone else) to say what aspects of PPIP or TALF 2.0 will be the most successful, or the most profitable for investors. It is likely that some of the new PPIP-focused offerings will perform well and that some will fall flat. The Treasury Department's main goal is to help cleanse bank balance sheets, and by doing so, it hopes to help rebuild portions of the fixed-income markets that broke. Improvement in those areas could benefit mutual funds investors indirectly. We wouldn't expect a full recovery or ample gains across the board, but the possibility of investors recovering even some lost ground is a welcome prospect. We will certainly weigh in as developments in the PPIP and TALF 2.0 programs evolve. Those developments, in combination with the economic and political factors mentioned above, could paint a much clearer picture in the not-too-distant future.

Morningstar fixed-income specialist Eric Jacobson contributed to this article.