By Randy Myers
The push by wrap issuers for more conservative stable value investment guidelines may have heightened the tension between issuers and fund managers, but it doesn’t appear to be threatening their symbiotic relationship. In a panel discussion at the SVIA’s 2010 Spring Seminar, for example, one leading fund manager conceded that his company was in agreement with most of the changes being imposed by wrap issuers.
Issuers began pushing for tighter investment guidelines in the wake of the 2007-2008 credit crisis, which temporarily drove the market value of many stable value funds below their book value. Had stable value investors exited those funds en masse at that point, wrap issuers could have been called upon to make up the difference between the market and book values of their accounts. That didn’t happen—investors actually flocked to stable value funds rather than fleeing them—but it convinced wrappers that their business was riskier than they once imagined.
Robert Whiteford, managing director in the global structured products group at wrap issuer Bank of America, told seminar participants that the push for more conservative investment guidelines is critical to the long-term health of the stable value industry.
“A lot of people believe we (wrap issuers) are getting tough just because we can,” Whiteford said, alluding to the recent scarcity of wrap capacity as banks and insurance companies have sought to bolster their capital reserves. “That’s not the case. Historically, we looked at this business as having a low level of risk, but that has changed in a big way.”
Prior to the credit crisis, Whiteford explained, wrap issuers implicitly trusted that stable value managers would structure their portfolios to ensure a “manageable” level of investment risk. Instead, he said, some took more risk in a bid to generate higher yields for investors. “There also were isolated circumstances where managers were living within the letter of their investment guidelines, but not so clearly within the spirit of their guidelines,” Whiteford said. “While everything worked out pretty well, thanks to the diligence and hard work of a lot of people, it is a different world now. It’s not as safe as it once was.”
The upshot, Whiteford said, is that wrap issuers are pushing for investment guidelines that eliminate or reduce the use of some of the riskier assets that had found their way into stable value portfolios, such as non-investment grade securities or exotic asset-backed securities. Many are also seeking to eliminate currency risk and leverage from stable value portfolios, and are pushing for greater diversity and transparency in those portfolios.
“I don’t believe any wrapper is taking advantage of the dearth of wrap capacity to make changes,” he said. “I think all these risk changes are necessary. We have to look at the risk characteristics of our products, and manage that risk, and the economics of the business, in a way that makes sense. What we’re trying to do is consolidate the risks in this business and prepare ourselves for future growth.”
Erol Sonderegger, director of client portfolio management for stable value manager Galliard Capital Management, said his firm is “on board” with about 80 percent of what wrap issuers are demanding, though he fears the pendulum may have swung too far on the remaining 20 percent.
He criticized, for example, the tendency for some wrap issuers to “over rely” on credit ratings when determining which securities a manager should be allowed to hold in an investment portfolio. “Rating agencies are what got the financial industry into a lot of trouble in the last couple of years,” he said, alluding to their willingness to assign investment-grade ratings to mortgage-backed securities and collateralized debt obligations that proved to be extraordinarily risky. “While ratings are important yardsticks, just like benchmarks, I think we should think this through a bit and be a little flexible.”
Sonderegger also encouraged wrap issuers to allow managers to incorporate into their investment guidelines sufficient flexibility to work out of investment positions that become stressed. “We believe that stable value still has a tremendous value proposition,” he said, “and that within that, active management of stable value is as strong as ever. Prudent active management proved its worth during the crisis.”
Even with the more restrictive guidelines being imposed, Sonderegger concluded, “there is still plenty of room for stable value managers to add value” for their clients.
During a question-and-answer period following the panel discussion, one seminar participant, a stable value manager, complained that her stable value fund was being subjected to the same investment guideline pressures being brought to bear on others, even though her fund, which included an allocation to high-yield fixed income securities, never saw its market-to-book-value ratio fall below 100 percent during the financial crisis. Subjecting the entire industry to the same, uniform investment guidelines, she said, “is hurting managers like us who have had good experience, decades of experience, managing fixed income assets, and it is making all managers seem very generic.”
Whiteford said he was sympathetic to that argument and urged managers who believe they are being reined in unfairly to make “a strong, cogent, analytical case” to their wrap issuers as to why they should be allowed to pursue their preferred investment strategy. “I believe all wrappers will look at it and give it the right time,” he said. “But they are going to have to make the case to a number of other people in their organization who are going to be skeptical.”
Marc Magnoli, executive director of JPMorgan Chase’s Stable Value Products Group and chair of the SVIA, added, “Our concern as wrap providers is, how bad will thing get if they get bad again? We do understand that managers have different styles, but once guidelines are written, we don’t have any control over what goes on in the portfolio. We want a situation where managers can’t create portfolios that, when things go bad, look like the portfolios we had in the last crisis. We believe it is prudent and appropriate to have preservation of principal as a foundation principal on which stable value portfolios are managed.