Home > Library > Stable Times > Volume 10, Issue 2  

Stable Value Managers Find Prudent Ways to Boost Returns

With the yield curve relatively flat and credit spreads tight in recent months, it is difficult for stable value asset managers to bolster returns through plain vanilla strategies such as duration extension and investing in credit-sensitive securities. But as three stable value managers explained at the Stable Value Investment Association's 2006 Spring Seminar in Henderson, Nevada, there are other ways to improve investment performance without assuming significant additional risks. The strategies used by these managers include: investing in non-U.S. dollar bonds hedged against currency risk; overlaying a fixed income portfolio with currency and non-dollar, fixed income futures; and exploiting term, credit, volatility, and transactional liquidity premiums in the bond market.

Stable value manager AllianceBernstein has used hedged, non-dollar sovereign bonds to boost returns in its stable value portfolios. Greg Wilensky, Director of Stable Value Investments for the company, explained that the strategy involves simultaneously buying non-dollar bonds, selling U.S. Treasuries, and selling foreign exchange forward contracts to hedge currency risks. While hedged, non-dollar sovereign bonds do not always outperform other stable value assets, Wilensky noted that they have provided very consistent returns if the investments are limited to situations in which hedged, non-dollar bonds offer incremental carry after adjusting for the foreign exchange contracts. This generally occurs when foreign-yield curves are relatively steeper than the U.S.-yield curve, regardless of overall yield-curve levels.

To demonstrate the potential of this strategy, Wilensky compared a wrapped portfolio of bonds tracking the Lehman Brothers Intermediate Aggregate Bond Index to a comparable portfolio in which an average of 10 percent of the assets were shifted into the "positive carry," hedged, non-dollar-bond positions. Over the 15-year period from 1991 through 2005, the blended portfolio that included the non-dollar securities provided an annualized excess return of 20 basis points relative to the U.S.-only portfolio, with only 28 basis points of tracking error. A crediting rate simulation for the same portfolios, looking at the same 15-year period, showed that the blended portfolio would have yielded a higher crediting rate about 80 percent of the time.

Deutsche Asset Management began using an innovative alpha overlay strategy in its stable value mutual fund in 1999, where it generated positive returns for five consecutive calendar years. While that fund has since been converted to a short-term bond fund, Deutsche Senior Portfolio Manager Brett Gorman said his firm began offering this "enhanced stable value" strategy to its defined contribution plan clients last year. On January 1 of this year, the strategy was implemented for a $610 million stable value fund Deutsche manages on behalf of one of its clients.

Deutsche's strategy involves taking tactical long and short positions in fixed income futures and foreign currency markets in major developed markets around the globe. The strategy is designed to generate marginal return predominantly in the form of alpha-returns attributable to the inherent value of the securities in the overlay portfolio-rather than beta-the volatility of the markets in which the securities trade. The overall target, Gorman said, is 100 basis points of excess return, with only a 1 percent increase in volatility.

Not all alpha overlay strategies would be appropriate for a stable value fund, Gorman cautioned. In a stable value environment, he said, managers must be able to employ robust risk controls, trade in highly liquid markets, and strive for a net position that has a low correlation to the U.S. fixed income market.

The stable value managers at PIMCO, one of the largest specialty, fixed income managers in the world, have developed yet a third approach to boosting portfolio returns. PIMCO's approach relies not only on traditional active-management strategies, such as sector selection or duration management, but also on seizing what it calls structural opportunities in the market. Over a five-year time period, said PIMCO Vice President Bret Estep, the firm expects the latter approach to add as much as 30 to 50 basis points of additional returns annually.

In broad strokes, the PIMCO approach seeks to capture term, credit, volatility, and transactional liquidity premiums in the bond and cash markets. The cash market is important to PIMCO because it often uses bond futures in its stable value portfolios as a substitute for actual bonds. The use of futures allows the firm to achieve the same exposure to bonds but with only a small collateral deposit, leaving the firm with a sizeable amount of cash to invest.

One way PIMCO seeks to enhance the returns on its cash position is to invest not in three-month Treasury bills, the traditional risk-free marker, but in six-month or 12-month T-bills or even investment-grade corporate securities of comparable maturity. These investments provide a higher yield, Estep explained, while exposing the fund to only a modest amount of additional risk. PIMCO also seeks to capture what it calls a transactional liquidity premium by including in the cash portion of its portfolio securities that aren't immediately redeemable. They might, for example, settle three days after trading rather than one day later. By doing this, PIMCO avoids paying the liquidity premium embedded in the price of more liquid securities.

In the bond market, PIMCO captures a credit premium by adding to its portfolio securities that are just slightly lower in credit quality-say Double-A or Double-A-Plus-than the Triple-A rating of the Lehman Aggregate Bond Index. Finally, it seeks to capture a volatility premium by exploiting what it says is the common mispricing of options. For example, Estep said, PIMCO believes most investors pay an excess premium for price stability, and it seeks to take advantage of that inefficiency by "selling" volatility. It can do this by selling fixed income options or purchasing securities with embedded options, such as mortgages.

All of these strategies involve marginal risk relative to a more traditionally managed stable value fund. This reinforces the importance of full disclosure and communication between portfolio managers, stable value managers, pension plan sponsors, and participants. It also requires that procedures and systems be in place to appropriately evaluate, price, and manage those risks and ensure that the fund is adequately compensated on a risk-adjusted basis.

Read Next: Editor's Corner