Could a Rising PPIP Tide Lift Your Bond Fund Boat?

What the Treasury's Public-Private Investment Program could mean for mutual fund investors.

Michael Herbst 20 May, 2009 | 0:00
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The answer depends on whether your boat was skimming the waves in 2008, took on a little water, or sank to the bottom of the ocean. The U.S. Treasury Department is set to announce the first five asset managers to participate in the Public-Private Investment Program, or PPIP (pronounced pee-pip), in coming weeks. Those eligible to participate are likely to include the likes of bond heavies such as PIMCO, BlackRock, or Western Asset Management. Given such firms' high profiles in the fixed-income world, and given the government's intention to reach out to a broader swath of investors in its efforts to bolster capital markets, it is a natural question to ask what PPIP means for bond mutual fund investors.

The answer has several parts and is likely to evolve in coming months. PPIP and its cousin, the Term Asset-Backed Securities Loan Facility, or TALF, are intended to resuscitate several pockets of the bond markets that essentially shut down in 2008. PPIP and TALF will focus on bolstering the markets for nongovernment mortgage-backed and asset-backed securities. Treasury's goal for the five initial asset managers is for each to bring at least $500 million to the table in relatively short order. Treasury then intends to match that funding 1:1, meaning that at least $5 billion could begin to pour into market over the summer. Treasury may bring even more resources to the table by expanding TALF to include certain kinds of commercial and residential mortgage-backed securities, and make the funding available to investors well beyond the initial five (an expansion becoming known as TALF 2.0).

No Use Trying to Push Square Pegs into Round Holes
Investors looking for PPIP-oriented open-end mutual funds aren't likely to find any. That's because the government's financial investment alongside the initial participants involves an aspect of leverage that doesn't jibe with the Investment Company Act of 1940. In addition, even with the help of new PPIP cash, the securities in the spotlight are likely to remain quite illiquid and could present challenges for open-end fund managers who need to be able to accommodate investor redemptions. As a result, the initial PPIP asset managers are discussing limited-partnership investment vehicles more akin to hedge funds or private equity investments than open-end offerings for retail investors.

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.

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Michael Herbst  Michael Herbst is an associate director of fund analysis with Morningstar.

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