By Randy Myers
Rising interest rates can be a challenge for stable value funds, and after years of falling rates, many in the stable value industry are wondering how they will react when rates finally do rise. Their attention is focused especially on pooled funds, since a single pooled fund can manage assets for hundreds of retirement plans.
The central concern is that the participants in those plans, in search of higher-returning investments, might pull money out of their stable value fund en masse. That would be an issue any time, as it would require the fund to liquidate assets quickly to meet redemption requests. It would be especially problematic in a rising- interest-rate environment, however, since the market value of the fund’s underlying investment portfolio would likely be less than its contract value at that time.
In that situation, the issuers of the fund’s wrap contracts could be forced to step in and cover the difference between contract and book value. That way, the fund could meet its promise of contract-value redemptions to plan participants. That would be good for the participants leaving the fund, but not so good for those remaining, as it would likely lead to higher fund costs in the future. Accordingly, all of the other parties involved—stable value managers, wrap-contract issuers, and plan sponsors—hope to avoid triggering wrap contract coverage unless it is absolutely necessary. Like other types of insurance, wrap contracts are something that stable value funds need but hope they never have to use.
For insight into how pooled funds might perform in a rising-rate environment, The Vanguard Group recently analyzed how its pooled stable value fund would react not just to a moderate increase in interest rates but to a sharp and sustained rise.
The company found that the fund would have fared quite well, Susan Graef, a principal at The Vanguard Group, told participants at the 2011 SVIA Fall Forum.
Graef runs the stable value team at Vanguard. She explained that her group began its analysis by looking at its own stable value fund at the end of February 2011, when it had a market-value-to-contract value (MV/CV) ratio of 103.5 percent. Its underlying portfolio of fixed income investments had an average duration of 2.6 years, and its crediting rate was 3.27 percent. For purposes of the stress test, Vanguard assumed that the fund’s duration, convexity, and key rate duration distributions, as well as the option-adjusted spread on its underlying investments, would remain steady throughout the time period studied. The company further assumed that changes to the “yield to worst” of the fund’s underlying investment portfolio would follow Treasury-curve rate changes.
To come up with a suitably rigorous stress test, Vanguard looked for a real-world example: the most severe period of interest rate tightening by the Federal Reserve since 1980. It found it in a two-and-a-half-year period from October 1986 to March 1989 during which yields on three-month U.S. Treasury bills shot up 382 basis points. Yields at the longer end of the yield curve rose substantially as well.
Next, Vanguard looked at how its fund would have fared, beginning in February 2011, if rates moved that dramatically again. It modeled three different scenarios. Under the first, or base-case, scenario, it simply layered on the same interest rate changes that took place in the 1986–1989 period. Under the second scenario, it assumed the same interest rate changes but also calculated that for every month in which yields on money market funds were within 50 basis points or less of stable value funds, some plan sponsors would leave the fund, withdrawing 5 percent of its assets. Under the third scenario, it again assumed the same interest rate scenario, but calculated that for every month where the fund’s MV/CV ratio fell below 98 percent, some plan sponsors would leave the fund, this time withdrawing 10 percent of the fund’s assets each time.
Stable value funds have not experienced withdrawal rates on that magnitude, Graef noted, but she said Vanguard wanted to create a severe stress test. To further exaggerate the negatives, the test assumed that although plan sponsors normally must wait 12 months before they are entitled to contract-value withdrawals in rising rate environments, they would be allowed to make them just one month after the triggering events built into the stress test.
Under the base case, the fund’s MV/CV ratio fell to 97.4 percent from 103.5 percent during the period when the Fed was tightening, then recovered to 100.1 percent within 12 months after the tightening ended. While price returns on the fund’s underlying portfolio turned negative, cumulative interest earnings produced a positive total return for the period.
Under the second scenario, 25 percent of the fund’s assets were withdrawn around the peak of the Fed’s tightening period. The fund’s crediting rate declined but held above the three percent level. The MV/CV ratio hit a low of 97 percent, recovering to just over par three months later. Again, the cumulative total return for the period was positive.
Under the third scenario, the calculated crediting rate again stayed above 3 percent, and the cumulative total return for the fund’s portfolio again was positive. However, total assets in the fund fell by 55 percent during the tested period, the bulk of that during one six-month stretch.
While a 3 percent crediting rate may not have proved very competitive under the circumstances contemplated in the analysis, Graef said the study showed that the effect of rising rates on stable value funds, and their impact on MV/CV ratios, may not be as negative or severe as some might have expected. In the case of the Vanguard example, she attributed this to a variety of factors, including the fund’s diversification of investment holdings across the yield curve, the tightening of interest rates over a period of time rather than all at once, and the beneficial impact of income earnings offsetting capital losses. She also noted that the competitive threat from money market funds under the scenarios tested was limited by the ability of the stable value fund to continue offering a relatively high and stable crediting rate.
