Stable value funds differ from total-return-driven fixed income products. They generally put capital preservation ahead of aggressive yield generation. In that respect, they tend to build portfolios of “laddered” fixed income securities, positioning them to manage the ebbs and flows of liquidity needs when used as a cash alternative in a defined contribution retirement plan. The approximate average duration for stable value funds is around three years, roughly half the duration of the Bloomberg Barclays U.S. Aggregate Bond Index. Lower duration generally means less sensitivity to changes in interest rates, and milder downside portfolio impact in a rising rates scenario.
To put things in perspective, the pandemic-related market correction in the first quarter of 2020 was a liquidity-driven event rather than a credit-driven event. The surprising element, aside from the speed of the sell-off, was the severity of the weakness in short duration fixed income, including commercial paper, treasuries, mortgages and structured credit. It was an unusual market environment forcing the Fed and the U.S. Treasury to inject substantial liquidity into the markets to backstop the deterioration (the U.S. Treasury provided an equity cushion for the Fed for a more aggressive funding ability). Even though the liquidity storm impacted stable value in the short run, these funds continued to see inflows of new capital during the quarter and on a year-to-date basis. A rapid recovery in the equity markets did not meaningfully change that picture. So, the question is: do stable value funds deserve more serious consideration today?
The Impact of Interest Rates
The critical background here is the shape and the management of the yield curve. Recent announcements from the Federal Reserve offered the markets new guidance. First, the Fed strengthened its position on zero-bound short rates and pinned its reference rate near zero. Further, it has modified its inflation targeting process, which is now based on an “average” as opposed to an absolute level (the averaging period is not disclosed). This will likely lead to lower short-term rates for a longer time period. Further supporting downside protection is a “willing-and-able” Federal Reserve on standby, with a view that once the dust settles following the elections, more fiscal stimulus will arrive, if necessary, in 2021.
Not surprisingly, the prime or government money market funds will likely experience more pressure to generate an attractive after-fee yield. That does not mean investors will completely exit these funds, but given their mandates, they will likely provide subdued return potential for investors who use these funds as a safe-haven option. Safety in this context does not mean safety against inflation though. This is where stable value funds may stand out as a complementary option ̶ investing in fixed income securities with longer duration and wider credit spreads. Mixing in spread products with safe haven treasury bonds accomplishes two objectives: 1) the portfolio yield improves and 2) the sensitivity to rising interest rates declines. If the expectation is that short-term rates will likely remain flat over the next several years, with a potentially steeper yield curve, stable value funds emerge as a compelling strategic alternative to money market funds.
Wrap Providers and Principal Protection
In 2020, stable value funds have provided liquidity in a weak market, taking advantage of the inflows. Furthermore, U.S. companies have rushed to raise cash following the first quarter, expanding the opportunity set for all fixed income funds in general. By September 2020, U.S. corporations raised $1.9 trillion according to the Financial Times,1 already exceeding the previous year’s full year issuance. The recent shift in asset flows from equity and money market funds into fixed income funds is an indication of the market’s appreciation of increased opportunities on the supply side, lower return expectations from money market funds, and relatively wider credit spreads compared with the pre-pandemic tightness.
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One of the features that sets stable value funds apart from other fixed income products (outside of the tax-exempt world) is their ability to provide principal protection to cover portfolio losses in worst-case scenarios. This is accomplished by using a pool of insurance companies, called “wrap providers.” When compared with the financial crisis, there are a larger number of wrap providers today and they have been more lenient during market stress. In the first quarter of 2020, they extended the recovery window for impaired credits, continued to provide ample capacity, and maintained the cost structure around 15 basis points to 20 basis points in most cases. Wrap capacity is instrumental to stable value funds’ ability to operate and carry certain assets at book value to maintain their tax-exempt status. Insurance companies price the wrap fee considering other competing businesses that require balance sheet capacity, and it is often an active/negotiated contract between the stable value managers and the insurance companies. While there may be some room for lower wrap fees, they are not far off the all-time lows pre-2008.
Market-to-book values have also improved substantially from the lows in the first quarter. Most stable value funds reported sub-par market-to-book values mostly driven by weaker credit-sensitive positions like BBB investment grade credits (particularly in the energy, financial and transportation sectors), but the higher quality portion of the portfolios (including treasury bonds) rallied driven by lower rates. Since the first quarter through September month-end, the market-to-book ratios have recovered substantially in the 102% to 105% range (some funds reported higher values). The associated crediting rates generally move much slower than the market-to-book ratios, as the book-value accounting allows for amortization of the market-to-book premium or discount across the duration of the portfolio, smoothing out the mark-to-market impact. In general, with lower interest rates and tightening credit spreads, the crediting rates may continue trending lower, but unlike money market funds, that happens slowly and gradually (it can take several years).
The application of the book-value accounting and other liquidity characteristics ̶ such as commonly used 12-month puts (for plan level departures from a stable value fund) ̶ act as a shock-absorber that matches portfolio liquidity and investor liquidity. In many cases, where liquidity is available, 12-month put provisions as well as 90-day wash rules for participant transfers can be waived if it is determined that transfer would not disadvantage remaining investors.
Utilization of Stable Value Funds
Fiduciaries are increasingly using stable value funds in asset allocation products. Aside from being featured as a stand-alone investment option in retirement plan lineups, stable value funds are making their way into custom target date products as a fixed income alternative. Their principal protection feature bodes well for wealth preservation as participants systematically withdraw retirement income from their defined contribution nest eggs. Stable value investment strategies with a principal preservation feature are increasingly being used to protect account balances later in the accumulation phase and throughout retirement in custom target date products built from plan lineups or in a CIT chassis (Collective Investment Trusts). The inclusion of stable value in custom target date solutions, as well as their guaranteed retirement income product cousins, are starting to bring defined contribution participant retirement outcomes closer to those of defined benefit plans, a likely trend over the next decade.
A Better Version of Stable Value?
The stable value industry has gone through a transformation during the post-financial crisis period. Total assets under management have reached more than $800 billion according to the Stable Value Investment Association.2 After the financial crisis, most stable value funds have reduced their exposure to relatively more esoteric asset classes like sub-prime mortgages (also called reperforming loans) and emerging market debt. In this market environment where short-term interest rates are near zero for the foreseeable future, stable value funds may provide a better yield and better protection against inflation when compared with money market funds. There are unique liquidity considerations when investing in stable value funds, but the first quarter’s pandemic-related turbulence showed that the industry, and the associated players, proved to be in better shape to manage the liquidity needs of plan sponsors and participants.
1 Financial Times, US corporate bond issuance hits $1.919tn in 2020, beating full-year record, September 2, 2020.