Meeting the Challenges of a Low Interest-Rate Environment

When it comes to interest-rate risk, the focus for the stable value industry has always been on rates rising steeply or suddenly, which would be a major change from today’s sustained low rate world. The issue for stable value is whether retirement plan participants would flee the asset class in favor of money market funds, where returns to  investors tend to immediately follow in a rapidly rising rate environment.

Today’s low interest rates are the more immediate concern, however. Short-term rates have been hovering at historic lows for the past year, and the Federal Reserve has indicated that it plans to keep them low at least until mid-2015. Over time, low rates drive down the crediting rates that stable value funds promise to their investors.

Many in the industry have been wondering just how low they might go over the next few years, and how that might impact stable value’s appeal to retirement plan participants. For answers, analysts at New York Life Investment Management LLC looked at how stable value crediting rates have held up over the past six years as short-term interest rates have fallen to historically low levels, and projected how crediting rates might fare if interest rates stay low for the next few years. Aruna Hobbs, managing director and head of Stable Value Investments for New York Life Investment Management LLC, presented the findings at the 2012 SVIA Fall Forum.

Over the past six years, Hobbs noted, the yield on the 5-year Treasury note has fallen more than 400 basis points to less than 1 percent. During that same period, the yield on the investment portfolios underlying stable value funds, as measured by the Wrapped Barclays Stable Income Market Index, also declined, but by less than treasury yields: from about 2.8 percent to about 1 percent. Crediting rates for stable value funds fell much less, though, going from about 2.8 percent to roughly 2.5 percent.

Crediting rates fell less than interest rates, Hobbs said, in part because of the way crediting rates are calculated. They benefit from the amortization of prior market-value gains recognized in stable value funds’ underlying investment portfolios. In effect, in a falling rate environment, those gains cushion declines in the crediting rate.

That cushion should continue to moderate the decline in crediting rates between now and 2015 even if yields on stable value portfolios continue to decline, Hobbs said. Her firm’s analysis shows that even if those yields fall to just under 0.5 percent by July 2015, stable value funds should still be offering crediting rates of about 1.25 percent. And their market-value-to-book-value ratios should hold up too, standing at about 102.2 percent at the end of the period.

“A continuing pattern of lower interest rates,” she concluded, “doesn’t present a significant or material risk to us.” Hobbs and her colleagues also looked at what would happen in more unusual circumstances—say, a credit impairment event, such as a default or downgrade of investment securities in the fund’s portfolio. Hobbs noted that due to the cushioning effect of prior market gains, established stable value funds would fare better in the aftermath of a credit impairment event than new stable value business issued at par—with a market-to-book ratio of 100 percent.

“Does this provide an analysis of the entire range of plausible and possible outcomes?” Hobbs asked. “No. But if we’re talking about preexisting business with healthy market-value-tobook- value ratios, especially if it was business issued over six to eight years ago, it does show that type of contract can sustain pretty long periods of low interest rates. In the case of an impairment event, the ultimate impact would depend on the magnitude of the event, the level of cushion in the portfolio, and other factors.”

Despite that generally positive assessment, the low interest-rate environment does present challenges for stable value managers, said Jennifer Gilmore, senior portfolio manager and head of stable value portfolio management for INVESCO Advisors Inc. One is to find investments with sufficient yield without running afoul of investment guidelines. With lower yields, she observed, funds also have less cushion to absorb wrap, investment management and administrative fees. Finally, she said, new portfolios are difficult to fund where the existing market-value-to-book-value ratio cannot support a higher crediting rate.

Nick Gage, head of the Client Portfolio Analysis team at Galliard Capital Management, said that despite the challenges of a low rate environment, stable value portfolios remain healthy. He emphasized that Association statistics supported the strength and resiliency of stable value.

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