Classic: The Ins and Outs of Stable Value Funds by David Merkel, CFA of Aleph Blog
The following article was published at Realmoney.com in 2004. Rates were lower then but the issues remain the same.
My 401(k) plan has a stable value fund that currently pays a preannounced annual rate of 5.30 percent. The fund enters into guaranteed investment contracts (GICs) with insurance companies which invest in government and corporate bonds and mortgages. I’ve heard that stable value funds can now be purchased outside of retirement plans. Does anyone know of any fund families or brokers that offer these funds to individual investors? – Reader Question from M. J.Morningstar Investment Conference: Fund Manager Highlights Personalized Medicine, Energy Security
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In my career, I have run a GIC (Guaranteed Investment Contract) desk at an insurer, designed one stable value fund, and helped administer and invest for several others. I know stable value funds, respect them, invest in them when it makes sense, but I am still a skeptic at some points.
Legal Risks Lead to Elimination of Non-401(k)-type Stable Value Funds
Last year, there was a big scandal over mutual fund pricing, and non-401(k)-type stable value funds came under the microscope because of the obvious difference between the value of the assets and the stated NAV of the funds. The SEC made an inquiry about the accounting for the funds in December 2003. Since then non-401(k)-type mutual funds have died a slow death. There is one left, and they are probably going to turn the fund into a short term bond fund, as the others did. Their reason for existence has gone away, and now they are expensive short-to-intermediate term bond funds.
Your opportunity to invest in stable value funds outside of 401(k)/defined contribution world has gone away, but given that there is over $200 billion invested in stable value funds, and not much has been written on them from a third party point of view, I’ll describe them in more detail.
Defining the Investment
So what’s a stable value fund? It’s a short-to-intermediate term fixed income pool that has some agreements on the side to allow the assets to be accounted for at book value, so that the investment accrues at a positive rate. It looks like a savings account to the investor, not a short-to-intermediate term bond fund. Because it invests at longer maturities than money market funds, they deliver higher yields than money market funds, except in years worse than 1994, where yields rise rapidly and the yield curve inverts. (Stable value funds did not exist in the 1979-1981 era; perhaps money market yields would have been higher than stable value yields would have been then. The precursor to Stable value funds, initial participation guarantee funds, ran into trouble then. That trouble led to the development of GICs.)
A stable value fund invests in insurance contracts, money markets, and highly rated (usually AAA) short-to-intermediate term bonds. Insurance contracts are always valued at book value, unless in default, which we saw a little of in the early 90s. Among major GIC writers, default has not been a problem since 1994. (General American gave us a scare in 1999; Metlife bought them, and all payments were made.)
The bonds held in stable value funds can’t be valued at book value because accounting rules require that they be held at market. The stable value pool goes out and purchases derivatives known as wrap agreements in order to allow the bonds to be held at book value. The wrap agreements agree to pay or receive money if any of the bonds have to be liquidated at a loss or gain respectively, thus making the fund whole for any book value loss. Typically, wrap agreements are only done on the highest rated bonds (AAA), so credit risk is not covered by most wrap agreements. With most wrap agreements, once a payment is received or made by the wrapper, the wrapper enters into a countervailing transaction with the pool to pay or receive, respectively, a stream of payments over the life of the bond that was wrapped equal to the present value of the initial payment when the bond was tapped. The wrapper bears almost no risk in the arrangement; the risks are rated back to the stable value pool, and the stable value pool pays for the gains and losses through an adjustment to the pool’s credited rate.
Since wrappers bear almost no risk, wrap pricing in 401(k)-type plans is typically 0.05%-0.10%/year of assets wrapped. The only risk a wrapper faces is that the interest rate-related losses on a bond in a rising interest rate scenario is so severe that the losses can’t be repaid out of the yield of the wrapped bond. In this case, the wrapper would have to pay without reimbursement.
Interest Rate Risks
Stable value funds attempt to maintain a stable share price, but the assets underlying the fund vary as interest rates, prepayment behavior and credit spreads change. There is almost always a difference between the book value of the assets, expressed by the NAV, and the market value. When the stable value fund has a higher market value than book value, typically it pays an above market yield.
There is a risk that in an environment where interest rates have risen sharply, that a stable value fund would have a lower market value than book value, with a below market yield. In a situation like this, particularly when the yield curve inverts, there is a risk that shareholders in the stable value fund will leave in search of higher yields. If that happens to a high degree, it will worsen the gap between the market value and book value of assets, which will be covered by the wrappers in the short run, but will reduce the fund’s yield as they pay the wrappers back.
It is unlikely, but possible to get a death spiral here, if more and more shareholders leave the pool and the yield sags to zero. It hasn’t happened yet, so this is theoretical for now. In theory, the wrappers would keep paying once the funds credited rate dropped to zero, so no one would lose money unless a wrapper defaulted on his obligation. There would likely be some legal wrangling in such an event; the wrappers might try to get the fund manager to take on some of the liability. In 401(k) plans, there are limitations on transferring funds out of a stable value fund to funds that would offer an easy arbitrage, so the risk of a death spiral are further reduced, but not eliminated.
Asset Default Risks
As an aside, for the most part, stable value funds take little credit risk, but (little known) this is not universally true. Some of them buy corporate bonds, or other riskier structured product bonds. Some of them take credit risk in hidden ways. Here’s an example: there are some exotic, asset- or commercial-mortgage backed interest-only bonds that are rated AAA by the rating agencies. The agencies rate them AAA because they can’t lose principal; they have no principal to lose. But if the loans underlying the interest-only bonds default or prepay, the interest stream gets shortened. The sensitivity on these securities to default risk is more akin to BB or BBB bonds, but a manager using them can count them as AAA.
If an asset in a stable value fund defaults, the fund will likely temporarily suspend withdrawals while it pursues one or two courses of action. If the loss is small, they might buy a wrap contract for the loss, which will haircut the yield on the stable value fund for the life of the wrap contract. If the loss is big, they will reduce the NAV, and attempt to keep the NAV stable from there. Given the history of money market funds breaking the buck, it is possible that the fund manager might pony up the funds to make the stable value fund whole, but I wouldn’t rely on that.
There are two main risks: asset default, and severely rising interest rates. In exchange for those risks, what do you receive? In most circumstances, you get a higher yield than a money market fund, with nonguaranteed stability of principal.
If you need a good yield, and stability of principal with modest risk, a stable value fund can be a good place to get it. That said, if you can live with fluctuations in the NAV over the intermediate term, it would be better to use a short-to-intermediate-term bond fund, and thus avoid the wrapper and high asset manager fees. Stable value manager fees are typically higher than those for bond funds. Over a five-year period (or so), your total return should be better.