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Wrestling with Rising Rates: Stable Value Funds Face Difficult Choices

Few developments can be less kind to conservative investors than rapidly rising interest rates. Under such conditions, yields on competing money market and bond funds rise quickly too-potentially faster than yields on Stable Value funds-and threaten to siphon investor assets away from Stable Value funds. Such an environment kicked in earlier this year with bonds; from June 13 to August 1, the yield on the benchmark ten-year Treasury note soared to 4.43 percent from a 45-year low of 3.11 percent, marking, according to ICMA Retirement Corp., the fastest such jump since 1987.

Yields on the ten-year note were still hovering in the 4.4 percent range by mid-October, and economists were widely predicting that interest rates will move higher over the next 12 months. That leaves managers of Stable Value funds mulling options for competing in what could be a tougher interest rate environment.

Because investors in Stable Value funds generally care as much about the safety of their principal as they do about earning competitive returns, one option for managers is to simply stick with those strategies that have made Stable Value an investment success for decades, even if it depresses crediting rates to participants. According to Karl Tourville, Managing Partner at Stable Value Manager Galliard Capital Management Inc., this would include managing Stable Value portfolios to maintain adequate liquidity for whatever redemptions do materialize, and continuing to invest those portfolios in low-risk, short-term, high-quality assets. "Don't wrap equities, don't invest in a lot of untested asset-backed securities, and keep your portfolio durations low, say in the 2 ½-2 ¾-year range to three years at the outside," Tourville told attendees at the SVIA's 2003 National Forum in Washington, D.C. At his own firm, Tourville noted, portfolio managers often include Treasury Inflation Protection Securities, or TIPS, in their portfolios to protect against an inflationary environment, even though doing so can reduce their portfolio yields over the short term. (Ordinary Treasuries typically boast higher starting yields than TIPS.)

To be sure, not everybody is expecting a Stable Value tsunami. Seth Ruthen, an Executive Vice President with Stable Value Manager Pacific Investment Management Co., told Forum attendees that while his firm expects interest rates to rise over the next five years, it anticipates a slow increase, not a furious one. Even if interest rates do rise, he explained, long-term return prospects for the fixed-income market remain solid. While an instantaneous 200-basis-point rise in ten-year Treasuries' rates would produce an approximately three percent negative return for the CitiGroup Broad Investment Grade Bond Index over the ensuing year, for example, annualized returns for the index for two-year and longer periods would still be positive-as high as 4.47 percent for five years and 5.76 percent for ten years, he said. An immediate 100-basis-point increase in rates would not produce negative returns for the CitiGroup index in the first year or subsequent multi-year periods, he added. Ruthen noted that the CitiGroup index had a duration of 4.7 years as of July 31, 2003, longer than most Stable Value portfolios. "With durations as short as they are for your portfolios," he told Stable Value managers attending the SVIA forum, "we think your chances of having zero percent returns down the road are very muted."

All that said, Stable Value managers who wish to be aggressive in responding to a rising rate environment do have numerous options available to them, another panelist indicated. One such option is to shorten the duration of their portfolios by investing in shorter-maturity assets, thereby making it easier to quickly redeploy those assets into higher-yielding securities as they mature. The problem, of course, is that fund managers could find themselves squeezed if, for example, their very-short-duration investment portfolio is yielding one percent and the crediting rate they are obliged to pay investors is, say, five percent. Alternatively, aggressive managers could consider diversifying their portfolios to hold investments that Stable Value managers typically shun, such as equities.

John Moroney, Manager of the Stable Value funds Group at Rabobank International, which provides wrap contracts for Stable Value funds, says the many alternative portfolio strategies available to funds today gives wrap providers more confidence in backing the book-value guarantee on those funds, as does the availability today of participating wrap contracts in which plan participants assume some of the risk in a rising rate environment. However, Moroney suggested wrap providers would draw the line on wrapping investment portfolios they deem too risky. He, for example, would be leery of Stable Value funds including equities in their underlying investment portfolio. Thomas Coleman, a Fixed Income Product Manager with Wellington Management Co., added that creating a portfolio with a very long duration, or one that included "truly low-quality assets" might be unattractive for Stable Value funds, too.

In fact, most Stable Value managers are likely to proceed cautiously before venturing too far beyond traditional Stable Value investments. "We are focused on retaining our core investment discipline, not taking big bets outside our normal strategies," said Mark Foley, Senior Product Manager for CIGNA Corp.'s $22.8 billion Stable Value business. As another Stable Value manager addressing the conference noted, clients routinely say they want one thing above all others from their Stable Value fund: no blowups. That is a message the Stable Value industry has always taken to heart.

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