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This Is Not Your Old GIC Manager Any More

During September and October of 2004, my firm conducted a series of 20-30 minute interviews with senior professionals at seventeen of the leading investment management firms in the stable value market, representing over $180 billion in stable value assets under management.

The primary objectives were to highlight the evolution of stable value portfolio management since the early 1990's, and to provide insight into how managers are navigating through changing seas – dealing with unprecedented low fund yields while trying to ensure that those yields will move in tandem with rate increases. The stable value market has never truly experienced this phenomenon over an extended time period, rather, benefiting for years from the many downward moves in rates. Participants would naturally expect portfolio yields to move with rate levels. If that didn't happen, it could be a problem for the industry.

The results of the study reveal that today's stable value investment management is not your father's GIC management. It closely resembles traditional fixed income management, yet with a high credit quality bias and a greater focus on liquidity. We have an eclectic mix of firms in the market - “traditional” stable value managers, fixed income managers with stable value sub-specialties, “traditional” fixed income managers with stable value “teams”, and sponsors which have branched out. When asked what these managers believe are their keys to long-term success, they most frequently cited duration management, security selection, diversification, liquidity management, sector selection, and credit research. I for one remember the stable value/GIC symposia where panel members would endlessly debate how many GIC issuers a portfolio should be diversified amongst and investment managers would argue with plan sponsors the merits of external vs. internal management. Stable value management has certainly come a long way!

Evidence of a continued move toward stable value becoming a niche within fixed income management, is the increased incorporation of total return management into portfolios. Actual usage of total return strategies varies from 10% to 100%, indicating a fundamental difference in how managers believe portfolios should be managed. The primary rationale for more versus less total return is related to liquidity concerns – those without large allocations ensure portfolios have sufficient liquidity by maintaining laddered portfolios, while those with large allocations tend to focus more on building liquidity and flexibility into their wrap contracts. In most cases, total return portfolios are buffered by short-term investments and GICs (if applicable) in order to avoid having withdrawals disrupt investment management decision-making.

As the chart below illustrates, 70% of stable value managers interviewed indicated they would still buy traditional GICs. However, these managers will not afford GICs any special treatment and view them as they would any other security – simply a “tool in their tool belt.” While people still desire the non-participating, fixed rate features of GICs, especially in certain environments, the illiquid and undiversified nature make them less comfortable. Therefore, a GIC will generally only receive serious consideration when its option-adjusted spread is viewed as attractive relative to other assets. As a result, only 6% of managers interviewed had increased their allocations to GICs in recent years, while the rest had either decreased or held their allocations constant.

With regard to interest rates, while we have already seen curve flattening, I wanted to find out whether or not managers believed the curve would flatten more and whether or not they were positioning their portfolios accordingly. Each manager interviewed expected the curve to flatten more over the next year or two, and approximately ¾ of the managers have made tactical moves to capitalize upon a flattening curve – the remaining ¼ of firms were doing nothing differently, believing their strategies would ultimately pay off. While some of these moves were modest in scope, and some were more significant, the most popular were to shorten duration (26%) and put on barbells (21%).

On the duration side, the chart below shows that 53% of managers interviewed have shortened durations in this environment while 41% have held durations constant (only 6% increased duration). Where durations were shortened, the most popular reason was to maintain portfolio responsiveness for when rates move higher, with the next most popular reason to make a yield curve “bet”. While these proved to be costly decisions in terms of yield, due to a steep curve, those managers believed the correct decision was to be well-positioned should rates rise rapidly. For those managers who did not change duration, the rationale was to stick to their stated strategy of maintaining constant durations.

It seems logical to assume that managers may be introducing more credit risk into portfolios in order to diversify and pick up yield. And, it does appear that more managers would consider adding more corporates but very tight spreads have severely limited corporate weightings. However, there is little desire to move down the credit curve in order to do so. 88% of managers interviewed said they would not move down the credit curve into below investment grade securities in order to pick up spread. The most frequently cited reason is the fundamental belief that dipping down in credit quality would not be consistent with the principal preservation objectives of stable value. Thus, most managers retain a high quality bias and maintain average portfolio credit quality levels of AA or higher.

All of this might make you wonder whether the investment managers believe stable value to be different from other fixed income portfolios. The results were split right down the middle, illustrating the diverging viewpoints being employed within the industry. The most frequently cited reason for managing stable value differently was the nature of the liquidity/liability profile and a need for greater conservatism.

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