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Stable Value Industry Weathers Liquidity Test

In the most extraordinary example of cash flow volatility that most professionals in the business have ever seen, investors stuffed money into Stable Value funds during the fourth quarter of 1999, then yanked it out at a fast rate in the first quarter of 2000. While the resulting liquidity squeeze caused many investment managers to scramble for cash just as the value of their assets was declining, all were able to make good on their promise to satisfy withdrawal requests at book value.

The rush to Stable Value late last year was prompted by fears that the Y2K computer bug could wreak havoc on the economy and the stock market. When the bug proved benign, and the stock market continued to post heady gains, investors flocked out of Stable Value and back into equity funds. According to data compiled by the Hueler Companies, Stable Value fund cash flows averaged between -0.9% and +1.6% during 1999, but grew to -7.1% in the first quarter of 2000. At the extreme, some funds experienced withdrawals in excess of 18.3%. Particularly hard hit were funds in defined contribution plans where the investment options included technology-oriented mutual funds, or company stock in which the company was a high-tech concern.

Despite the turmoil, many investment managers were able to weather the storm using routine liquidity strategies that performed as expected, with no extraordinary impact on their funds. Most traditional managers simply worked through their standard hierarchy of liquidity mechanisms to meet withdrawal demand, for example, starting with tapping new deposits, then maturing contracts, then cash buffers, and finally with selling some of the securities inside their wrap contracts. Managers who no longer rely upon preset maturity schedules also fared well because their "evergreen" portfolios afforded them plenty of flexibility and liquidity.

In other cases, managers were able to get the liquidity they needed as the result of precautionary measures they took late last year, when it looked like the Y2K "crisis" could rock the financial markets. Dwight Asset Management, for example, put a number of windowed GICs onto its books late in 1999 to help it manage liquidity. (A windowed GIC is structured to have a targeted funding level and a finite period of time during which it will accept deposits. It will take deposits up to and above the targeted level. Then, if the total deposits exceed the target, the excess monies are returned to the fund, where they are available for reinvestment or to satisfy withdrawal requests.)

"We structured our windowed GICs to accept cash flows and provide liquidity from the fourth quarter of 1999 through the first quarter of 2000," said David Richardson, a managing director and portfolio manager for Dwight. "They worked as designed."

Another large investment manager relied on a heftier-than-normal cash position to help it weather the storm.

"We had built up a lot of cash heading toward year-end 1999 because we didn't know what to expect from investors, and that proved very helpful in meeting our liquidity needs, as did our laddered maturity portfolio structure," observed a portfolio manager at this firm. "As a consequence, we didn't have to restructure any of our portfolios. However, we did access our wrap contracts in one or two plans, which is something that from time to time will happen for us anyway."

Jo Ann Davis, a principal at State Street Global Advisors in charge of that firm's Stable Value investment group, says her firm weathered the liquidity crunch without taking any extraordinary measures, thanks to an investment strategy built on "well-laddered portfolios" that feature contracts maturing on a rolling monthly basis. Between December 31, 1999, and February 29, 2000, the total cash position declined 20%, before recovering to more normal, pre-December '99, levels in March. However, less than 1% of the firm's book of business was impacted. "Our strategy held up under the gun," Davis says.

To be sure, the industry sustained some minor bumps and bruises. For example, some investment managers were compelled to access their investment contracts for liquidity at levels that produced losses for the issuers. It was a rare and by most accounts unprecedented event, but not a devastating one.

"We saw investment managers using a wide variety of strategies to meet their liquidity needs, from beefing up their cash positions to restructuring contracts to accessing those contracts," says Aruna Hobbs, director of institutional products and head of Stable Value business at AEGON Institutional Markets, a unit of Dutch insurer AEGON N.V. "But what we saw was that the liquidity management practices used by our clients were very closely aligned with what we anticipate in our risk models when we underwrite this business. The industry might have scrambled a bit during the first quarter-especially during January and February-but it wasn't the sort of thing that caused us to panic."

Steve Butters, managing director for wrap issuer CDC Capital Inc., takes a similar view. He says that just two Stable Value funds that do business with his firm accessed their wrap contracts in the first quarter.

"I've been in this business for 12 years, and this is the first time I've been involved in any contracts that were unexpectedly invaded for benefits," says Butters. But noting that his firm has about 350 contracts outstanding, he says the hits weren't dramatic "from a big-picture perspective." Rather, he says, they were newsworthy simply because "it never happened before."

There were persistent though unconfirmed reports during the first quarter that some investment managers took measures to avoid accessing their wrap contracts where doing so would have inflicted losses on the issuers, even though their contracts would have permitted it. On the surface, such behavior would seem implausible-akin to a motorist declining to file a claim against his auto insurer after denting the family sedan. But just like the motorist trying to avoid a future increase in insurance premiums, managers who shied away from accessing their wrap contracts could argue that their investors would benefit over the long term.

"When you start exercising benefit responsive provisions of your contracts and cause the issuers to experience losses, it affects their view of the risk in that portfolio or that management style," observes a senior portfolio manager at one investment firm. "Subsequently, they may charge higher wrap fees or simply refuse to underwrite that business."

Indeed, Butters reports that the two plans which accessed their wrap contracts with CDC and other issuers have effectively been forced back to the drawing board to create a new set of operating rules.

A key concern in determining whether or not to access an investment contract for liquidity, of course, is how it will affect investment results going forward. When managers who use conventional laddered portfolios restructure them to gain liquidity, they often change the duration of their portfolio unintentionally. They also sacrifice the opportunity to reinvest at current market interest rates.

"When managers restructure assets to meet unexpected liquidity needs, that tells us that those portfolios are operating inefficiently and may sacrifice results," says Vicky Paradis from J.P. Morgan Investment Management.

Whether the first quarter's extreme cash-flow volatility will prove a harbinger of trends to come or merely an isolated event remains to be seen, as will its impact on wrap pricing. Many industry observers suspect that active trading by investors in defined contribution plans is a novelty that will eventually lose some of its popularity, and that cash flow volatility will trend back toward its historic levels.

In the meantime, the upward pressure on wrap pricing that one would expect in the wake of the first-quarter activity isn't in evidence. One wrap issuer noted that with money flowing out of Stable Value funds recently, there's been far less demand for wrap contracts recently than there was at this time a year ago. That lack of demand appears to be countering the pricing pressure caused by the liquidity crunch.

"My thought is that the cash flow volatility of the first quarter should have had an impact on prices," observes Butters. "But my observation is that it hasn't. In part that's because the volume of business being passed around today is a lot less than was being passed around last year at this time."

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