While most of the concern pertaining to the potential rise in interest rates has been focused on fixed income funds, stable value funds have been significantly impacted as well. Pooled stable value funds are essentially fixed income portfolios supported by insurance wraps or guarantees. Therefore, they carry a significant level of interest rate risk. The market value of the underlying fixed income portfolio will decline as interest rates rise. Participants do not experience these market value fluctuations due to the products’ insurance component. However, last year’s rise in interest rates had a potential negative impact on the liquidity for stable value funds at the plan sponsor level.
Due to their protective structure from market value losses, stable value funds come with added liquidity restrictions that other fixed income funds do not have. Participants are restricted from selling a stable value investment and purchasing a competing investment option (such as a money market fund or in some cases a short-term bond fund) within a 90 day period. Participants are generally able to redeem their own shares at book value, or 100 cents on the dollar, regardless of the underlying market value of the product’s assets. If a plan sponsor wishes to terminate a pooled stable value product, they may be required to wait in a put queue (which is typically 12 or 24 months) depending on the ratio of the fund’s market-to-book value of assets. For separate accounts and insurance GICs (Guaranteed Investment Contracts), plan sponsors may be subject to a market value adjustment or an extended termination period depending on the asset values. The greater the difference of the market value of assets over the book value, the more likely it is that the fund will not impose liquidity restrictions on termination requests.
Heading into May of 2013, many stable value funds had a market value in excess of 102% of book value. On May 1st, the yield on the ten-year U.S. Treasury was near an all-time low at 1.66%. Rates began to spike sharply higher during the first part of the month due to concerns that the Federal Reserve would begin to wind down their quantitative easing program sooner than expected. By June 25th, the yield on the ten-year U.S. Treasury had climbed to 2.60%. Rates continued to drift higher over the second half of 2013, with the ten-year U.S. Treasury closing the year at 3.04%. This move in interest rates wiped out most of the market value premiums that existed earlier in the year.
Presently, many investment managers still have a market value of 100%, or just slightly above book value. Despite recent market changes, most managers remain generous and still keep a loose policy on sponsor liquidity. Therefore, some sponsors may be able to exit their products without being subject to the full term of a 12 or 24 month put. The relatively loose restrictions also apply to most Insurance guaranteed products, which may still not require a market value adjustment, as many market values in their underlying portfolios remain above book value.
However, the decline in these market value premiums has resulted in a loss of a protective buffer that could have helped offset future market value declines. Most of these products continue to have a duration in excess of two years, with some funds having a duration of up to five years. In order to protect against potential rising interest rates, most stable value managers had shortened the duration of their portfolios. These actions lowered the yield on their portfolios, which reduced the crediting rate offered to participants. Currently, most stable value funds have not further shortened their durations out of fear of shrinking the yield on their funds even further. If interest rates continue to rise, especially if there is another quick spike in rates similar to last spring, stable value funds have the potential of falling below book value. Once this occurs, the fund will be more likely to implement the full put in response to plan-level redemption requests.
PEI continues to believe that stable value funds remain strong capital preservation options within an overall plan lineup. However, it is important for plan sponsors to understand how their stable value funds have been affected by the recent rise in rates, in addition to what steps the managers have taken to adjust their portfolios. Most products still maintain a market value slightly in excess of book value. However, that margin of safety has diminished since last spring, thus making it more likely that stable value funds may implement liquidity restrictions should interest rates continue to rise over the near term.