PSNC 2014: Fixed Income and Stable Value

The stable value market has changed significantly post financial crisis, says Josh Kruk, head of stable value portfolio management at Dwight Asset Management, and the evolution is ongoing.

This means plan sponsors, who are bound by a fiduciary duty to regularly monitor and adjust their plan’s investment menu, must identify and respond to new emerging risks and opportunities in stable value offerings and fixed-income portfolios more generally. The matter is complicated by the expectation that interest rates may rise in the short or medium term, Kruk says, presenting a new and increasingly complex picture for sponsors and workplace retirement investors.

Kruk and a number of other stable value experts addressed the topic of fixed-income and stable value investments during a panel discussion on the second day of the 2014 PLANSPONSOR National Conference, in Chicago. Panelists reminded attending sponsors that, although conservative in nature, stable value funds have a general investment objective of providing a greater return over time than money market funds. One of the key strengths of a stable value fund is low volatility, Kruk says.

“This reliability of this asset class was really proved during 2008 and 2009,” Kruk says. “On the whole, the asset class performed exactly as intended during the crisis, and there’s not a whole lot more we could throw at it than what we saw in 2008 and 2009.”

But that doesn’t mean stable value products don’t carry risk, Kruk warns. The stable value asset class may look simple on the surface, he admits, but the tranquil exterior hides an absolute whirlwind of bond holdings, insurance arrangements and wrap contracts that can challenge the understanding of even the most financially savvy sponsors. It would be impossible to fully explain the inner workings of stable value during one 45-minute presentation, Kruk says, so instead he teaches sponsors about the key risks that should be monitored.

The first and probably most familiar risk for stable value is interest rate risk, he says. Effective management of interest rate and extension risk within stable value portfolios is particularly critical in the current environment, Kruk says. 

Interest rates in the U.S. have been hovering around all-time lows for years, due largely to sustained downward pressure applied by the Federal Reserve or Fed. Kruk and other panelists say they expect the Fed to carefully and slowly raise rates as the economy continues to strengthen, perhaps to 3% for short-term rates by 2015. If rates rise slowly, stable value should be able to respond effectively, Kruk says, but a rate spike is always within the realm of possibility should inflation surge.

“The impact of a significant increase in rates on the market-value-to-book-value (MV/BV) ratios of stable value portfolios could be substantial,” he says. “During the credit crisis, the industry witnessed MV/BV ratios dip to the low 90% range in some cases.”

As Kruk explains, when the market value of a stable value fund falls below its book value, the fund has essentially failed to deliver on its objective of not giving up any value. “While this prior episode was largely the result of credit-related stress, one could envision a scenario where interest rate stress could lead to a similar outcome in the future,” Kruk says.

Another risk to stable value from rising rates could result from exposure to the agency mortgage-backed securities sector. It’s a complex risk, Kruk says, but over-extension on mortgage-backed securities duration could cause portfolios to hit the explicit caps on duration that many wrap contracts for stable value products now impose, resulting in forced asset sales that effectively lock in rate-driven losses.

The second risk is also somewhat familiar for sponsors, Kruk says, and relates to credit and liquidity concerns. Following the financial crisis, some stable value providers have narrowed the definition of acceptable credit risk in investment guidelines. Changes have typically included the elimination of high-yield exposure, Kruk explains, as well as tighter caps on the allocation to lower-rated securities, especially those below BBB. Providers have also sought to limit exposure to any single bond fund or insurance provider, Kruk says. Still, credit risk is present at both the sector and issuer levels, and, in some cases, through exposure to derivatives counterparts.

Periods of market stress can impair stable value liquidity, Kruk explains, causing transaction costs to increase due to wider bid/ask spreads. When crafting the investment portfolio for a stable value client, managers should take into account considerations of the portfolio’s liquidity profile and the impact that transaction costs may have on the investor experience across various market environments.

Some plan-specific factors that garner the most focus, Kruk says, include participant demographics, recent cash flow experience and the degree to which plan participants move assets among plan options in response to external influences, especially equity market performance. Due to the mechanics of stable value withdrawals, persistent negative participant cash flow can exacerbate any MV/BV deficit, Kruk warns.

The sponsor’s business and industry profile also may be important in determining how best to construct the stable value portfolio, Kruk says. Wrap contracts are structured to pay book value for plan participant activities, but wrap providers will not bear unlimited risk for participant withdrawals, Kruk explains.

“In fact, certain sponsor activities could result in the payment of market value rather than book value, which under certain market circumstances can mean significant losses for participants,” Kruk says. “Sponsors absolutely must be aware of what these triggers are and be careful to avoid them. While there is currently an average MV/BV premium in the industry, this may not be the case in the future.”

Further, since wrap contracts expose sponsor clients to an element of counterparty risk, effective ongoing assessment and management of that risk is critical, Kruk says. Sponsors should certainly benefit from employing a knowledgeable adviser or consultant who can assist with negotiation and monitoring stable value contracts.

Finally, the utilization of third party sub-advisers as part of an overall stable value solution drives another important facet of risk management, Kruk says. When properly selected and utilized, sub-advisers can add style diversification and potential “group think” risk mitigation for the portfolio, he explains. However, it is critical for sponsors to ensure their stable value manager is confirming these sub-advisers have a sound investment process, good technology/physical infrastructure, and sound internal controls.