By Randy Myers
The long downward trend in interest rates since the early 1980s has been beneficial to the stable value industry. Now, many economists believe that trend is in jeopardy, prompting questions about how the industry will respond.
Declining rate environments favor stable value funds because their crediting rates—the actual earning rates posted to investors account balances—react more slowly to changes in interest rates than do yields on competing money market funds. This is often referred to as a “lag effect” of stable value crediting rates lagging changing market rates. Speaking at the SVIA’s 2010 Spring Seminar, Karen Edgerton, senior vice president with AEGON Stable Value Solutions Inc., pointed out that rarely over the past 20 years have existing stable value fund crediting rates lagged money market yields, and even rarer that new investment yields available to stable value portfolios have lagged money market yields. The former is true because money market yields generally do not move up fast enough to overcome the lag effect, and the latter is true because it is unusual for yield curves to be inverted for long periods of time. That has given the stable value industry a leg up on the money market industry in the competition for investor assets.
Now, however, economists fret that growing federal budget deficits will prompt a flood of borrowing by the U.S. government, driving interest rates higher for years to come. “We do expect them to rise, we’re just not sure when and at what magnitude,” Edgerton said. “As they do, stable value crediting rates will lag. And the ability for retirees and terminated vested (retirement plan) participants to move into competing funds is there. We have concerns about how that population will react, and also about the possibility of mass movements of money out of stable value funds at a time when the market value of the underlying assets may not be sufficient to fund those redemptions.”
Still, Edgerton said there are mitigating factors that should temper any fallout from a rising rate environment. For example, most stable value funds prohibit direct transfers into competing funds, such as money market funds. They also contain corridor provisions that limit the percentage of a contract that may be paid out at book value as a result of participant withdrawals following certain employer-initiated events, such as a significant early retirement program or layoff. Beyond that, she said, participants have repeatedly demonstrated that they like what stable value funds offer. Over time, she said, “We’ve seen at most plus or minus 10 percent movement in and out of the funds, mostly correlated to equity markets performance.”
Edgerton also noted that stable value managers, as plan fiduciaries, work hard to keep their products attractive for retirement plan participants, which should serve them well in a rising rate environment.
If rates were to rise very sharply, Edgerton conceded that stable value funds could sustain a reduction in market-to-book ratios within their investment portfolios. Under one theoretical scenario she examined, funds could experience this reduction if rates jumped by more than 4.5
percentage points in a single year. That’s unlikely but not impossible; rates jumped nearly that much in March 1980 and by 5.57 percentage points in July 1981, she said.
Stable value managers can mitigate interest rate risk by adjusting the duration of their portfolios and by taking the demographic characteristics of plan participants into consideration when doing liquidity planning and liability profiling, Edgerton said. Hedging interest rate risk also is an option.
John Axtell, managing director and head of stable value for Deutsche Bank, said it’s also worth noting that while interest rates have been in a general downtrend over the past two decades, there have been several shorter periods of rising rates along the way. During those periods, stable value funds have performed well, with market-to-book-value ratios generally fluctuating within a manageable range.
Beyond thinking about how they might react to a sustained rise in interest rates, Axtell said stable value managers and wrap providers should be asking how stable value funds are likely to perform if inflation becomes an issue. Like interest rates, inflation has been fairly benign over the past two decades. The last period of high inflation occurred between January 1977 and December 1982, with the annual rate of change in the U.S. Consumer Price Index topping out above 14 percent in the second quarter of 1980. In 1981, the Federal Funds reached 19 percent as the Federal Reserve battled to bring inflation under control.
This was a stressful period for stable value funds; Axtell said, noting that a hypothetical Barclays Intermediate Aggregate Index covered by a wrap contract would have seen its market-to-book-value ratio fall to 82 percent in 1981 before climbing back above 100 percent the next year.
What wrap issuers would like to know now is how plan participants are likely to react if such a scenario would unfold again. While it is difficult to theorize, he said, it is known that during that period from the late 1970s to the early 1980s, yields on money market funds and three-month Treasury bills were periodically higher than stable value yields.
Wrap issuers also would like to know, Axtell said, how stable value managers today would react in such a situation. “One idea often floated,” he observed, “is that we should just go to shorter durations with our investment portfolios.” And indeed, he said, that would help. While the hypothetical wrapped Intermediate Aggregate Index saw its market-to-book ratio fall to 88.8 percent at the height of the high-inflation, high-interest period from 1977 through 1982, he said, the ratio would have fallen only to 88.8 percent for a wrapped version of the shorter-duration Barclays 1-5 Year Government Credit Index. However, that improved minimum market to book ratio would have come at the expense of a 50 basis points reduction in the average annual return for the 33-year period from January 1977 to January 2010.
“Fortunately, inflation expectations have inertia,” Axtell said, explaining that many economists believe the Consumer Price Index would have to rise for an extended period of time before triggering significant inflation expectations. That would give managers ample time to adjust their portfolios.
Just in case economists are wrong, he said, stable value managers should be developing strategies now to manage through periods of inflation should they materialize. Options include not only shortening the duration of investment portfolios, he said, but reallocating portfolio assets among different sectors of the fixed-income market, hedging via futures and options contracts, and allocating some assets to Treasury Inflation-Protected Securities, or TIPS.
When Deutsche Bank recently modeled how a hypothetical re-allocation strategy along these lines might affect returns for a wrapped Barclays Intermediate Aggregate Index portfolio, Axtell said, the market-to-book ratio fell only to 92.7 percent instead of 82 percent. The reallocated portfolio also enjoyed an average annual return for the 33-year period ending 2010 that was 34 basis points higher than the plain vanilla Intermediate Aggregate portfolio.