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A Higher Performance Hurdle for Stable Value as the Fed Hikes Rates?(This may not be the same old interest rate cycle)

Stable value funds typically have a natural return advantage versus cash or money market funds. This advantage occurs when the yield curve is positively sloped, intermediate maturity investments backing stable value have a higher yield than cash alternatives. However, when short-term rates rise and the yield curve flattens or inverts, stable value's structural return advantage diminishes and could disappear.

In recent years, defined contribution plan participants have grown accustomed to the typically generous out-performance of their stable value fund versus their next-best conservative option, usually money market funds. A notable change in relative performance can create communications challenges for plan sponsors and withdrawal risks for managers if funds do not live up to participant performance expectations.

We could be facing these circumstances soon as the Federal Reserve continues on a path of raising short-term interest rates. Stable value funds will be increasingly vulnerable to underperforming money market funds if the Fed does not pause anytime soon at neutral policy, but instead heads straight toward tight monetary policy.

Despite the higher potential obstacles for stable value funds going forward, this article makes the case that underperformance is not inevitable. A broader range of investment strategies are available to today's funds that may not have been possible during past cycles.

Where have we been?
The stable value investment community has comfortably delivered heroic investment results versus money market funds for several years. Short-term interest rates, as evidenced by the Federal Reserve Board's fed funds target rate, have hovered at multi-decade lows since October 2001, when the Fed first lowered the target rate below three percent, including 12 months at the all-time low of one percent. As short-term interest rates hit new lows, intermediate rates also fell, though not by quite as much. The yield curve remained relatively steep for much of that time, with five-year Treasury yields ranging from a low of 2.03 percent in June 2002 to a high of 4.15 percent in August 2005. Investors consistently earned comfortable margins versus cash simply from investing in longer maturities. In addition, with credit spreads over Treasuries, stable value funds typically produced outsized relative returns. This heroic performance cycle, however, is winding down.

The stable value industry clearly has weathered many interest rate cycles before. Yet the current environment may not be the same as previous interest rate cycles. The Fed has achieved remarkable success and credibility in its campaign to combat inflation and inflationary pressures, so intermediate rates have remained low, and could continue to stay low. Meanwhile, short-term rates are likely to continue rising.

Where are we today?
Stable value fund returns have drifted lower, reflecting a dilution of higher returns from previous interest rate environments. Current yields on new stable value investments have remained stubbornly low despite rising short-term rates. As spreads have compressed, many investments going forward may arguably offer less compelling risk-adjusted return enhancement opportunities.

The implications are not insignificant. A sustained unfavorable yield curve means there is little room for error in managing stable value funds. Yet, what constitutes an "error" is an open question. Should stable value funds brace for inevitable underperformance versus money market funds, or should funds employ strategies to achieve higher long-term returns? With benefit responsive contracts that absorb market fluctuations, what is the ultimate definition of risk in a stable value fund?

I suggest that a fund's risk profile should minimize the likelihood of not meeting participant expectations. Coming from the recent favorable interest rate environment, virtually any stable value strategy has exceeded expectations. Yet going forward, the hurdle of participants' return expectations will be higher. The following are thoughts on minimizing the risk of underperforming money market funds in more challenging times. I frame this in terms of the two primary goals of stable value funds:

1. The most important stable value objective is preservation of principal. This goal is met with properly-structured benefit responsive contracts, which are achievable for a wide range of investment strategies.
2. The second objective is to generate competitive, responsive returns, which in turn are driven by the underlying investment strategy. Going forward, this will be the key differentiator among strategies.

Ultimately, the determinant of successful long-term returns hinges on developing an underlying investment strategy that answers questions centered on classic fixed income investing principles, including the following:

What is the optimal duration strategy?
• Is shorter better- in order to be responsive to rising rates? It may be useful to note that generally a shorter fixed income portfolio duration (e.g. two years) is more responsive to changing intermediate interest rates than a longer (e.g. four year) duration. However, short stable value duration is not more responsive to changing cash yields. In two to five years, interest rates are stable while cash yields rise, a short duration strategy may not be beneficial. Yield curve analysis can be useful in evaluating risk-return efficiency over time, as there are arguable "sweet spots" on the curve.
• Is it better to invest with a longer duration to generate higher long-term returns? How long is reasonable? How long is too long? To give some perspective, according to the Ninth Annual Stable Value Investment Association Investment Policy Survey as of December 2004, the industry average duration was three years, with the longest reported duration at eight years for an in-house managed plan.
• Yield curve positioning has been particularly relevant recently. Short duration assets have been punished with underlying market losses as the yield curve has flattened. "Bar belled" or "tiered" structures that had allocations to short-duration portfolios, for example, may have underperformed funds with the flexibility to avoid the worst-performing part of the yield curve.

While duration and yield curve positioning are quantifiable, visible measures of a fund's risk-return profile, other characteristics, namely sector allocation, may be a more significant differentiator of future success.

What is the optimal sector strategy?
A portfolio limited to the highest-credit-quality, simplest fixed income sectors has appeal for stable value. Yet such a strategy may unnecessarily compromise long-term potential returns. Instead, I suggest that participants can expect to benefit from higher potential returns and reduced portfolio volatility by investing in a diverse range of instruments that do not move in lockstep. Fortunately, funds have many choices in order to diversify.

Sector diversification does not necessarily mean heading into below-investment-grade territory. Clearly, below-investment-grade securities in modest amounts can benefit long-term returns and in fact reduce overall portfolio risk, yet they may create notable participant communication challenges and sector risk exposures.

Instead, a wide range of tools -- whether broader access to investment grade credit, the ability to invest in privately placed investments, or the effective use of derivatives -- can better manage risk and enhance returns. The goal is to generate additional cushion or downside protection against a rising interest rate environment.

The vehicle is often critical to effectively deliver broader sector access.
In considering broader access to sectors, it is often advantageous to consider a Fund vehicle, such as a mutual fund or commingled fund, to obtain optimal benefit. Specifically, credit sectors, including BBB rated investment grade bonds, are most effectively accessed when portfolio holdings are highly diversified. Conservative strategies should avoid concentrated credit positions. So, to the degree a fund vehicle can deliver exposure to hundreds of credits, name-specific volatility is reduced. The net result is an expanded overall opportunity set which tends to perform better with less volatility.

Fund vehicles often can more effectively access sophisticated exchange-traded or over-the-counter derivatives tools such as credit default swaps, options, and interest rate swaps. When used in conjunction with an overall portfolio strategy, these instruments can offer downside risk protection to a portfolio, as well as return enhancement.

Finally, there are investment sectors that cannot practically be accessed directly, such as privately placed mortgage or corporate loans. These investments are typically high quality, but are relatively illiquid individually. However, a fund vehicle can deliver the investment merits of these sectors in a highly diversified way that offers far better liquidity than directly placed loans.

Going forward, expect that successful stable value strategies will need to be nimble. This means that they should position for changing yield curve shape, as well as duration. In addition, management strategies should benefit from focusing on minimizing overall portfolio volatility through broader access to sectors and tools. The strategies should be the most likely to succeed at addressing participants' expectations and meeting the rising performance hurdle for stable value funds in the future.

Opinions offered constitute the author's judgment and are subject to change without notice. We believe the information provided here is reliable, but do not warrant its accuracy or completeness. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. This material has been prepared for informational purposes only

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