By Phil Connor, MassMutual
When individuals are faced with a personal decision sometimes they’ll resort to that familiar advice of “follow your instinct.” For stable value investments, a phrase such as “follow the yield” comes to mind when endeavoring to determine how the rate of return on the investment may trend over time.
Stable value investments appeal to retirement investors in defined contribution plans for their clear-cut expectations: a steady earnings rate on the amount invested and shielding of the account from market price fluctuations – such as those that occur with bond and stock funds – that may result in a reduction of the account’s accumulated value. The stable value fund account value consistently rises based on the rate of return. While these characteristics are forthright, an investor ought to have a solid understanding of the drivers of the current return and expectations about the future direction of the stable value yield. The primary focus for this understanding is the yield on the assets that are being managed to support the stable value investment. Those assets could be managed collectively within a trust or in a single-plan portfolio, or in an insurance company contract structure (whether general account or separate account). Regardless of the structure, having insight about the yield those assets are generating provides a main clue to what an investor may expect with regard to the overall stable value investment rate of return.
The yield on underlying assets is the focal point as it is the starting place for determination of the stable value investment rate of return, meaning that stable value investors can broadly expect the rate will trend toward the underlying asset yield. Hence the notion to, “follow the yield” when gauging how the rate of return on a stable value investment may change over time. In participating stable value investments, where underlying investment performance is factored into the rate, the underlying yield is adjusted for an amortization factor to recognize the difference in the market value of those underlying assets relative to the stable value investment’s book value (investor accumulated value based on the rate of return). This amortization, which means to spread out a financial impact over time, is designed to lessen the adjustment factor over time and allow the rate of return to become in synch with the underlying asset yield.
The main component of the adjustment factor is the difference in market value of underlying assets to book value, commonly referred to as the market-to-book value ratio. This ratio is broadly interpreted as a sign of soundness of a stable value investment, with a ratio greater than 100% indicating higher market value in support of the stable value investment. While it is an important factor in evaluating a stable value investment, and critical to understand factors like cash flow and asset performance that impact the ratio, it’s normal to see fluctuations of the ratio in a range that include levels both below and above 100%. An evaluation that primarily emphasizes the ratio may obstruct recognizing the underlying asset yield as a key driver of whether the stable value rate of return will move higher or lower.
For instance, having a market-to-book ratio of 102% would generally be a favorable indicator of the stable value product’s health. It indicates underlying assets have appreciated at a higher rate than the corresponding book value, providing additional financial security. It also implies asset yields have moved lower (values and yields move in opposite direction) and the stable value investment is earning a rate of return that is above current market rates. In participating structures, the extra two percent of value is used to enhance the rate relative to the current underlying asset yield. Given this, the important revelation is the stable value rate of return will be expected to move lower over time, outside of changes in market conditions and any impact from significant cash flows (as well as outside of any minimum rate guarantees). If the current stable value rate of return is 2% and expected to move lower due to the yield environment, there is little to be excited about from an earnings viewpoint despite the comfort of having assets that are greater than book value.
Compare the above scenario to a situation where market interest rates rise and result in a market-to-book value ratio of 98%. In this case, the expectation for the stable value rate of return is that it will be trending up over time. Which scenario would the stable value investor prefer? All else being equal, an investor would seemingly be better off with the higher return expectation, especially if higher market rates are a response to higher inflation. The lower market-to-book ratio is amortized back to 100% over time in the stable value rate of return calculation and is a trade-off in the opportunity to earn a higher prospective return.
In the normal course of market performance, the market-tobook ratio of stable value investments will fluctuate. A level below 100% shouldn’t be an all-in view of the soundness of the stable value investment; it is important however to recognize the factors influencing the level. In evaluating a stable value investment, it is a signal that underlying asset yields have gone up and that stable value investors stand to benefit from those higher yields over time. An underlying asset yield that is above the stable value investment’s rate of return is a positive indicator of the future trend, which should be contemplated alongside the current level of market-to-book ratio for a more complete view of expectations surrounding the stable value investment.