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A Role for Inflation Protected Securities in Stable Value Funds?

As we have discussed in our other article, Inflation Protected Securities (IPS) offer a risk return tradeoff that is quite different from nominal fixed income securities - most notably the ability to offer a guaranteed (in the case of TIPS, backed by the full faith and credit of the United States Government) real rate of return over the life of a security. Given this unique characteristic and the "real" nature of the liability faced by most 401(k) investors, what role, if any, can IPS play in Stable Value funds?

IPS could be used in Stable Value on either an opportunistic or a strategic basis. Below, we will evaluate each approach in turn:

Opportunistic Case

IPS provide an active manager with an additional tool to use in adding value in a Stable Value portfolio. A manager may derive value from investing in IPS when they appear undervalued relative to other securities available for investment. IPS may be considered attractive if a manager either expects real rates to fall, or believes that the breakeven inflation rate is too low. In both cases IPS stand to profit. Hence we believe that an opportunistic allocation to IPS, when the manager deems they are attractive, is beneficial in a Stable Value portfolio.

The issues surrounding the opportunistic use of IPS in Stable Value funds are not notably different than the issues for many other securities with less stable durations like MBS, non-dollar securities and high yield bonds. Since the effective durations may change frequently/dramatically, the overall portfolio duration can be affected and must carefully managed.

Including a modest amount of IPS in a Stable Value fund introduces some mild complications (discussed below) in the computation of the crediting rate if a portfolio based crediting rate formula is used. If a portfolio based crediting rate formula is used (i.e., the yield and duration of the portfolio are used as inputs into the crediting rate), a determination needs to be made on how the yield and duration for the IPS will be calculated. For the yield, will the real yield be used? Or will it be grossed up for inflation? If so, what inflation - last month's, a short term forecast, or a longer term forecast? For duration, will the mathematical duration be used or will it be converted to an effective duration using the historical or estimated relative yield volatility? While these issues require some additional consideration, they can clearly be addressed. Alternatively, an indexed based crediting rate formula (which we recommend) avoids these issues completely and is an appropriate for a modest allocation on an opportunistic basis.

Strategic Case

While there seems to be a clear case for opportunistic use of IPS in a Stable Value portfolio, the strategic case for IPS in Stable Value is not as clear. For our analysis of a strategic allocation to IPS, we will assume an entire Stable Value fund will be invested in IPS. While a wrapped IPS portfolio could easily represent only a fraction of a Stable Value fund's assets, this assumption will simplify the discussion.¹

While an Inflation Protected Security will have a guaranteed real rate of return over the life of the security, it's nominal return will vary over the life of the security, and the life time guarantee imposes very few restrictions on the path of returns. These volatility issues can be amplified further in the context of an IPS portfolio managed on a constant duration basis. By wrapping a constant duration IPS portfolio, we can smooth out their substantial return volatility in a similar fashion to wrapping nominal bonds.

Since the long-term real returns on an IPS portfolio will be more stable than the long-term real returns on a nominal portfolio, a wrapped IPS portfolio would do a better job of reducing swings in participants' real purchasing power than a wrapped nominal portfolio over the long run (Note: over shorter periods, the differences will be much more modest because the volatility reduction from wrapping the portfolios will be more important). For all Stable Value funds, the cumulative returns passed to all investors must equal-in the absence of any payments to/from the wrapper providers-the cumulative returns on the underlying investments.

With a properly structured wrapper contract, the crediting rate for a wrapped IPS portfolio can be more responsive than the typical Stable Value fund (holding duration constant) to changes in interest rates caused by changing inflation expectations. This is because IPS would not drop in value (or would drop by less than nominal bonds) if interest rates were to rise sharply because inflation expectations increased, bolstering the crediting rate so it tracks rising market rates more quickly than a regular Stable Value portfolio. (That is, since the IPS portfolio does not drop in value due to increasing inflation expectations, there is no loss to amortize into the crediting rate or offset the increasing nominal yield. On the other hand, the lag associated with changes in real interest rates would be similar to that of a nominal Stable Value fund.) Such dynamics could further reduce the odds that a Stable Value fund's crediting rate would lag behind money market returns in a sharply rising interest rate scenario. In other words, a wrapped IPS portfolio allows investors to take advantage of the higher expected returns typically offered by extending out the yield curve² from money market securities with a less pronounced lag affect. The improved tracking will result only if the issues regarding the crediting rate formula discussed above are properly addressed.

While the improvement in crediting rate responsiveness could be attractive, there is a substantial drawback to a strategic allocation to IPS in Stable Value funds. The long term expected return for IPS can be below the return on nominal bonds.

The Inflation Risk Premium

Since the owners of IPS are insulated from the real return volatility caused by investors' inability to accurately predict inflation, they should not be entitled to the "inflation risk premium" that is theoretically embedded in the yields offered by nominal bonds. This means that, in theory over the long run, an IPS portfolio should have a lower level of both nominal and real returns.

Fortunately, for current investors in IPS, this theoretical drag has generally not manifested itself in the IPS market. For most of their existence, the break-even inflation rate has been at or below the lifetime inflation rates being predicted by most economists. Therefore, the indicated inflation risk premium has been 0 or even negative (i.e., investors have not paid a premium for inflation protection, and have actually been paid to take less risk).

Limited Scope of Investments

Unfortunately, the second cause of return drag is very much a real world issue. Currently, with respect to USD denominated investments, the investable universe of IPS is limited to the 10 TIPS plus a very small group of other securities (most notably an Inflation Protect Security issued by the Tennessee Valley Authority). Therefore, in the absence of the use of derivative and/or leverage strategies, any IPS portfolio will be giving up the opportunity to earn compensation for taking on credit or structure/option risk.

Conclusion

Given significant relative value swings that have occurred between IPS and nominal bonds, a successful manager can clearly add value using IPS on an opportunistic basis. While we are excited by the prospect of incorporating the unique characteristics of IPS in Stable Value on a strategic basis, currently the limited diversity of issuers and securities as well as their limited track record makes us reluctant to recommend a strategic allocation to this sector at this time.

¹ For example, if only 25% of a Stable Value fund is invested in wrapped IPS, 25% of both the benefits and costs discussed below will accrue to the fund.

² If you have any doubt that the typical upward slope in nominal interest rates does not hold in the "real" space, consider that short T-bills currently offer negative real returns (there is not much disagreement about inflation expectations for the next month or so) while 5, 10 and 30-year TIPS currently sport real yields of .9%, 2.0% and 2.6% respectively.

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