Stable Value Funds: Proceed but with Caution


If you own a short-to-intermediate term bond portfolio, and you did not need to tap the cash for a few years, would you prefer rising short interest rates, or falling rates?  The correct answer is rising rates, because you will be able to reinvest interest payments paid in higher yielding securities.

That’s why I take issue with the following article on stable value funds from the Wall Street Journal.  Some might remember my “Unstable Value Funds” series.  Though the worst never happened, many funds came close to “breaking the buck.”

I once designed a substitute for Stable Value Funds, one that could trade on Schwab’s platform.  But the math of the product meant that it could be blown apart by a very rapid rise in short rates.  To try to remedy that, I rewrote the pension services contract to put in  a Force Majeure clause that would allow  the insurance company to alter many terms of the contract to avoid “breaking the buck.”   (In 1997-8, I thought ahead, and designed a contract that had modes for normal and abnormal environments. Hey, Nationwide Insurance, it’s your intellectual property now. Use it.)

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My main point is that stable value funds will lag in a rising rate environment.  Yes, it will not appear that you are losing money in the short run. but the credited rate will lag for 2-3 years, while returns to the short-to-intermediate term bond portfolio will be hurt in the short-run, but do well in the intermediate-term.

Be wary.  Even though Stable Value funds do not face credit risk problems now, rising rates would invite anti-selection by making short-to-intermediate term bond funds look attractive, even with the 90-day switch into equities or longer bonds.

Remember, Stable Value funds are bond funds that pay a little extra to guarantors, so that payments for death, disability, fund switching, etc., go out at book value.  They have to pay the fund management fees and the small guarantor fees.  The short-to-intermediate term bond fund can invest a little more aggressively, and only has to pay out the management fees.  Over the long haul, the short-to-intermediate term bond fund will beat most Stable Value funds, but the ride will seem more bumpy, because except in the worst scenarios, the Stable Value fund acts like a savings account, slowly accruing value, while the underlying investments actually behave like a short-to-intermediate term bond portfolio, with all of the volatility.

clostBy David Merkel, CFA of Aleph Blog

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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