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Home > Library > Stable Times > Volume 3, Issue 1  The quarterly publication of the Stable Value Investment Association First Quarter 1999 • Volume 3 Issue 1 Breaking into the IRA MarketBy Randy Myers For more than a year now, investors have been able to do something never before possible: open up the financial section of their daily newspaper and get a quote on a stable value mutual fund. It wasn't the newspaper industry that changed, of course, but the stable value industry itself. Leading the charge: Bankers Trust, which introduced its BT PreservationPlus stable value mutual fund for institutional investors in October 1997. At the end of last year, Bankers Trust scored another coup when it launched BT PreservationPlus Income Fund, a no-load, stable value mutual fund for the Individual Retirement Account market. Though just a niche right now, this market promises to become crowded quickly. Morley Financial Services launched the Morley Capital Accumulation Fund for IRA and institutional investors on February 1, and at least two more stable value mutual funds are due out for the IRA market in the next several months, including one from Dreyfus. The executives behind these ground-breaking funds say their decision to enter the IRA arena was a logical response to changes taking place in both the retirement marketplace and the stable value industry itself. "We recognized some time ago that the retirement plan market was moving more and more toward a retail orientation," says Morley Vice President Taylor Drake, who serves as co-portfolio manager for the Morley Capital Accumulation Fund. "Fidelity and other big fund companies have convinced investors that mutual funds are the key to retirement investing. This on-going advertising has increased awareness of mutual funds, and the Morley Capital Accumulation Fund gives us a product (type) that every investor on the street is familiar with." "We feel our stable value fund for the IRA market will be a source of growth in the future," adds Karl Tourville, managing partner at Galliard Capital Management in Minneapolis, which is developing a stable value fund for an undisclosed no-load mutual fund company. "It allows us to broaden the target market for stable value funds." Galliard expects its fund to be introduced within the next three to six months. Stable value products were shut out of the IRA market in the past, of course, because the Securities & Exchange Commission requires that mutual funds hold no more than 15% of their assets in illiquid securities. And traditional GICs, virtually the only type of security held in stable value products until 1990, aren't liquid. That hurdle was cleared over the past decade as innovative firms pioneered and refined the synthetic GIC. Today, a synthetic can consist entirely of highly liquid, intermediate-term fixed-income securities, all backed by a "wrapper" which guarantees the book value of those securities. Even with synthetic GICs, though, the stable value industry faced a daunting problem in developing funds for the IRA market. How would such a fund handle the risk of disintermediation, meaning the inevitable flood of redemption requests that would be triggered if interest rates suddenly spiked upward? Under such a scenario, the yields on money market funds would track the changing rate environment very quickly, prompting many IRA investors to swap assets out of stable value funds and into money market funds or other higher-yielding securities. Bankers Trust hit on this solution for the IRA market: it will charge a 3% redemption fee on withdrawals that take place whenever the interest rate environment is such that it would favor disintermediation. The only exceptions will be when the redemption is made due to the investor's death, retirement, or disability-the same three reasons which qualify for exemption from early redemption penalties levied by the Internal Revenue Service. Whenever the redemption fee is imposed, the proceeds will be funneled back into the fund, not to Bankers Trust. According to the terms of the PreservationPlus Income Fund's prospectus, the redemption fee will be triggered whenever the current yield on the fund, plus 225 basis points, is less than the yield of the Lehman Intermediate Treasury Index. Investors can call a toll-free Bankers Trust telephone number at any time to find out if this "Interest Rate Trigger" is in effect. In practice, it shouldn't be often. "If you look back over time, you'll see that the trigger doesn't come on very frequently," says Bankers Trust's managing director, Eric Kirsch. "It really comes on only when rates spike up, or when we have an inverted yield curve. In the early 1980s, when the Federal Reserve Board was raising interest rates and inflation was high, the trigger would have been on. But the only other time it would have been on since then was in 1984, when the yield curve was inverted. It would never have been on during the 1990s." The trigger goes off once the yield on the BT PreservationPlus Income Fund, plus 200 basis points, rises above the yield of the Lehman Intermediate Treasury Index. The 25-basis-point difference in the trigger's on and off calculations is designed to keep it from tripping frequently when rates are hovering near the trigger mark. To further avoid liquidity problems, Bankers Trust is keeping about 10% of its fund's assets in cash equivalents. The rest of the portfolio is invested in synthetic GICs backed by an intermediate-term bond portfolio that will maintain an average duration between 2.5 and 4.5 years. "It's a diversified portfolio," Kirsch says. "We'll invest in such sectors as U.S. Treasuries, asset-backed securities, mortgage-backed securities and corporate securities. From a credit-quality perspective, we can invest up to 10 percent of the fund in single and double B bonds, but the rest must be investment-grade securities with a rating of Triple-B or higher." (By contrast, the credit floor for its institutional stable value fund is Single-A.) Bankers Trust is purchasing the fund's wrappers only from institutions with claims-paying ratings of Double A Minus or better, and is using mostly hybrid and non-par wrappers. The expense ratio for the fund is pegged at 1.25 percent; Bankers Trust is absorbing some of the fund's costs while it is small ($5 million in assets so far) to keep that figure down. (Its institutional fund to date has garnered $290 million in assets.) Morley's no-load IRA fund, which carries an expense ratio of 95 basis points, is structured much like the BT fund, although the details of its redemption fee are slightly different. For starters, the fee is 2%, not 3%. Also, it's triggered when the gross yield of its fund is less than the Dealer Commercial Paper 90-Day Index, and applies to all withdrawals, regardless of the purpose. The trigger is reversed once the gross yield of the fund exceeds that index by at least 25 basis points. "We have not applied any waivers (to the interest-rate trigger) for our IRA class of shares," says Drake. "One of the reasons is that if you have somebody who's over age 65 and sitting on a huge IRA balance, they'd have an opportunity to arbitrage the Fund if those waivers are in place. In certain interest rate environments they would have a strong incentive to react to short-term movements in interest rates. Because the trigger is activated only under unusual market circumstances, we don't foresee our position putting us at a disadvantage in the marketplace." Morley is investing its fund's assets in fixed-income securities with a credit rating of Triple-B or higher, and has targeted an average portfolio quality of at least Double-A. Its target duration for its portfolio is 2 to 3.5 years. It will purchase wrappers from issuers with at least a Double-A claims-paying rating. Certus Asset Advisors, a San Francisco firm, which has used synthetic GIC products since their inception in 1990, will be managing Dreyfus' no load, stable-value mutual fund once it clears the SEC. In yet another approach to dealing with the risks associated with operating a stable value mutual fund for the IRA market, Certus and Dreyfus plan to use a dual interest rate trigger, one tied to short-term interest rates and the other to intermediate-term bond rates. Either one could activate the trigger independent of the other. "We think we have a valid reason for using two indices as triggers," says Certus Vice President Helen Napoli. "Yes, we're worried about people transferring assets to money market funds during an unfavorable rate environment, but we're also worried about those times when the portfolio's market value could be significantly less than its book value. By using two indices, we cover both risks." Certus will construct the Dreyfus fund's portfolio using a mixture of buy-and-hold synthetic GICs (that is, those that hold just one security to maturity) as well as synthetic GICs that incorporate a portfolio of actively managed fixed-income securities. The firms that have entered the IRA arena are taking slightly different tacks in marketing their products. Dreyfus will handle the marketing of the Certus-managed fund through its existing distribution channels. Morley, which is owned by Nationwide Financial Services, a national distributor of retirement products, plans to work initially through existing Nationwide and Morley distribution channels. Bankers Trust's is targeting the wholesale and financial-planning communities. "Lots of mutual fund companies don't have stable value capability," says Kirsch. "They'll ask, 'Should we build it or buy it?' We think they'll find it attractive to buy it from Bankers Trust on a wholesale level. In that vein, we're talking with banks, mutual fund companies and insurance companies." Whatever the distribution channel, expect the marketing pitch to be similar. "Because the stock market has been going great guns for so long, this is a good time to capture some of those investors who are looking for a way to lock up their gains, rather than to keep rolling the dice and assuming they'll get 25 percent a year from the stock market," explains Morley Senior Vice President and Managing Director Greg Ellis, who heads up the firm's sales and marketing efforts. "Also, the sheer demographics of the country are working in our favor; baby boomers are getting older, and whether they've run up a lot of stock market gains or personal income gains, they're looking toward retirement, and they're going to need a bit more safety from their investments." "Mutual funds allow us to follow the investor wherever he or she wants to go," adds Drake. "Now we can capture rollovers from the 401(k) and 403b markets, as well as accommodate any type of IRA investment, whether it's in a traditional IRA, a Roth IRA, an Education IRA, or even a KEOGH account." But is the IRA market destined to take off quickly? Probably not. As Certus President Robert McCormish explains, the yield curve is sufficiently flat right now that stable value funds are yielding only a bit more than money market funds, although historically the spread has averaged about 200 basis points. In mid February, for example, the BT PreservationPlus Income Fund was yielding about 5.2 percent, versus about 4.8 percent for money market funds. The yield on Bankers Trust's institutional fund, which was launched when overall interest rates were slightly higher, was about 5.85 percent. "We need some steepening of the yield curve and a commensurate shift in what stable value funds are returning versus money market funds to really put the stable value products on the map," McCormish says. "From then on, we'll benefit from the exposure IRA investors will have had to them." That being the case, it might appear that Bankers Trust, Morley, Dreyfus/Certus and Galliard are too early with their products. They don't think so. "We've had experience with both prospects and clients who've said they only want mutual fund options in their defined contribution plans," says McCormish. "And we've seen that with products like synthetic GICs and more sophisticated underwriting techniques, this is something we can deliver to the retail market. My gut says there's something to be had here, and if we don't try to find out, opportunity could sail by us." "The biggest risk in the long run," says Ellis, "is in not doing something like this."
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