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STABLE
VALUE
PERSPECTIVES
April 2013
STABLE VALUE AND RISING INTEREST RATES
Stable value funds have long been one of the most widely used defined contribution
investment options. Plan participants are drawn to this unique asset class because stable
value seeks to preserve capital and outperform money market funds with similar or lower
volatility. This attractive risk/return profile and stable value’s ability to historically produce
investment returns 100 to 200 basis points above money markets, has bolstered the popularity of stable value funds.
Andy Apostol
Senior Director
Todd Copenhaver
Associate
Galliard Capital Management
800 LaSalle Avenue, Suite 1100
Minneapolis, MN 55402-2054
800-717-1617
www.galliard.com
Stable value seeks to achieve its objectives by investing in short-to-intermediate duration
fixed income securities paired with stable value investment contracts (also commonly
known in the industry as “wrap” agreements).
Given that market interest rates are near all time lows, many investors see a rising
interest rate environment as an inevitability. If we are indeed faced with a paradigm shift
in rates, it is important to understand how this shift might impact stable value portfolios
from a portfolio risk and performance perspective. In order to provide an historical context
that includes multiple interest rate cycles and diverse market environments, this paper first
examines the dynamics of the stable value asset class over the past 15 years. We then look
toward a possible future of rising rates and explore how stable value might react to various
interest rate shocks. Finally, this study concludes with an analysis of how current market
expectations might affect a stable value portfolio.
Measuring Risk in a Stable Value Fund
There are many factors which contribute to the overall risk
profile of a stable value fund. The primary aspects that
should be evaluated when reviewing a stable value investment strategy include the following;
•
Credit quality and diversification of investment
contract providers and the fixed income securities in
the stable value portfolio
•
Contractual terms and provisions included within the
stable value investment agreement
•
Fixed income manager performance versus an appropriate peer universe and the strategy’s risk/return
profile
•
The stable value fund’s market-to-contract value
ratio (MV/CV)
In recent years, many plan sponsors have focused on
a stable value portfolio’s Market-to-Contract Value ratio
(MV/CV ratio). This ratio compares the market value of all
underlying portfolio investments to the value of the portfolio’s stable value investment contracts and cash equivalents
(its total contract value). It is a commonly held belief that
a key indicator of a “healthy” stable value fund is a MV/
CV ratio above 100% (a market value surplus). This ratio
often receives attention because it is easily quantifiable and
stable value strategies have exhibited surpluses over much
of the last two decades due to the secular decline in market
interest rates. While gains are not without merit, this is not
the “be-all indicator” of the overall health of a stable value
portfolio, and must be viewed in the context of the other risk
factors described above. It is important to also understand
that market value deficits (MV/CV ratio less than 100%) do
occur as a normal and expected part of a stable value fund’s
routine operation.
Stable Value Delivered Despite MV/CV < 100%
While higher interest rates in the future (and corresponding
lower bond prices) will apply pressure on a stable value
portfolio’s market to contract value ratio, it should not
be the basis for undue concern. Stable value has operated
seamlessly through periods where rising market interest rates
resulted in a market value deficit, such as in the 1998-1999
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| Stable Value Perspectives . April 2013
and 2003-2005 time periods. Even though the MV/CV ratio
of Galliard’s stable value composite touched 97% during
these two time periods, the investment contracts amortized
these losses through the crediting rate reset process and these
stable value portfolios continued to move towards parity.
The unprecedented spread widening of 2008 resulted in
the largest disparity on record for Galliard’s stable value
separate account composite (a 96% MV/CV ratio). As the
bond market stabilized, the MV/CV ratio of Galliard’s
It is a commonly held belief that a
key indicator of a “healthy” stable
value fund is a MV/CV ratio above
100% (a market value surplus)...
while these gains are not without
merit, this is not the “be-all
indicator” of the overall health of a
stable value portfolio.
separate account composite increased from its lowest point
on record back to parity within one year. Concluding stable
value underperformed during these time periods would have
been incorrect. In fact, stable value continued to provide
investors with attractive, risk-adjusted returns and capital
preservation while converging back to par from each market
value deficit.
Galliard’s research supports that the MV/CV ratio should
be expected to operate within a reasonable band, that crediting rates will continue to track the general direction of
market interest rates, and stable value will continue to
offer participants a safe haven with attractive risk-adjusted
returns.
Stable Value in Recent History...A Look Back
Before discussing a potential rising interest rate environment and its potential effect on stable value, it is helpful
to explore instances of both rising and falling interest rate
environments to better understand stable value dynamics.
To illustrate this, we will show contract and market value
relationships as well as return characteristics of a hypothetical stable value fund over the last 15 years. The model was
created using the actual return of the Barclays 1-5 Year
Government Credit Index in conjunction with stable value
investment contracts. For illustrative purposes, the following
standard crediting rate formula was applied to amortize the
hypothetical gains and losses and produce the contract value
performance record and crediting rates.
Figure 1 // Historical Return Comparison of Model
Stable Value Fund 1997-2012
8.0%
7.0%
6.0%
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%
Crediting Rate Formula
Net Crediting Rate = (MV/BV)^(1/D)*(1+AYTM)-1-C; where
MV= Market Value
BV= Book Value
D= Duration1
AYTM= Annualized Yield to Maturity=(1+YTM)^2-1
C= Contract Fee2
Table 1 below provides summary characteristics of the
stable value model portfolio. The model portfolio operated
in a gain during 76% of monthly time periods. This gain was
as high as 107.0% and the model recovered from a deficit of
2.5% (May 2000). The declining trend in rates resulted in an
average MV/CV ratio of 102.1%.
Yield
Net Crediting Rate
As Figure 1 illustrates, the crediting rate on the hypothetical stable
value portfolio performed as expected, tracking the general level of
market interest rates with a lag.
Figure 2 // Historical Surplus/Deficit of Model Stable
Value Fund 1997-2012
8.0%
6.0%
4.0%
2.0%
Table 1 // Characteristics of Model Stable Value Portfolio
Over the Last 15 Years
1.
2.
Percentage in Surplus
76%
Average MV/CV Ratio
102.10%
Largest Surplus (May 2003)
107.00%
Largest Deficit (May 2000)
97.48%
Gain/Loss Range
9.52%
Average Duration
2.48 years
0.0%
-2.0%
-4.0%
The stable value model operated predominantly with a surplus because
of the declining trend in interest rates (Figure 2).
Some contract issuers are now requiring a shorter amortization period for market value deficits in order to protect a stable value fund from an unmanageable deficit. More specifically, the
issuers stipulate that crediting rates be reset based on an adjusted portfolio duration if the market-to-contract value ratio falls below a certain threshold. By shortening the amortization
period for the loss, the crediting rate will more quickly narrow the gap between market value and contract value, improving flexibility for the investment manager and plan sponsor, as
well as preserving the long term health of the fund. The crediting rate formula used in this analysis includes a sample adjustment: (a) When the Market to Contract Value Ratio is below
98%, the crediting rate formula’s duration shall be 0.50 less than that of the underlying portfolio (b) When the Market to Contract Value Ratio is below 96%, the crediting rate formula’s
duration shall be 1.00 less than that of the underlying portfolio.
For model stable value portfolios, contract fee is assumed to be a 20 bps annual fee.
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Figure 3 below shows the growth of $100 invested in the model SV portfolio, the
Galliard Stable Value Composite and a money market fund3. Both the Galliard Stable
Value Composite and the hypothetical stable value portfolio significantly outperformed
money market funds. Outperformance increased as the Fed sought to stimulate the
economy by lowering short-term interest rates. The stable value returns were achieved
with only a fraction of the volatility experienced by traditional fixed income investments.
As the U.S. economy faces nearly unprecedented low yields, it is reasonable to assume
that rates will eventually reverse course and stable value could shift from operating in a
market value surplus to a market value deficit. It is therefore a prudent time to examine
the characteristics of stable value in a rising rate environment. Given the current interest
rate cycle, it is even more important that plan sponsors have at least a high-level understanding of how a market value deficit is not indicative of a poorly managed or unhealthy
stable value fund.
Figure 3 // Growth of $100 Over 15 Years
$220
$200
$180
$160
$140
$120
$100
1997
1999
2001
Model Stable Value Portfolio
2003
2005
Money Market
2007
2009
2011
Galliard Composite
3.
The growth of $100 shown in Figure 3 is a hypothetical illustration. The growth of $100 is before management fees but after contract wrap
fees. Management fees would reduce the growth of the $100 shown. The growth of Money Market shown is based on the returns of the
BarCap US Treasury Bills 1-3 Month index returns.
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| Stable Value Perspectives . April 2013
Given the current
interest rate cycle,
it is even more
important that plan
sponsors have at
least a high-level
understanding
of how a market
value deficit is
not indicative of a
poorly managed or
unhealthy stable
value fund.
A Primer on the Mechanics of Interest Rate Movements
Prior to examining market expectations for rising interest
rates and their effect on stable value portfolios, it is helpful
to examine highly simplified rate changes to understand the
basic mechanics of how a movement in interest rates affects
a stable value fund.
Figures 4 and 5 illustrate how a hypothetical stable value
portfolio 4 at a starting MV/CV ratio of 102% performs
when rates are held constant (the gray line), or when rates
rise one year from today by 50 bps (orange), 100 bps (light
blue), and 200 bps (red). In each of the scenarios, the
crediting rate moves towards the underlying fixed income
portfolio’s hypothetical yield to maturity as the portfolio
contract and market values converge. As market interest
rates are assumed to change, the crediting rates gradually
move towards the level of market yields as gains (losses) are
amortized and participants continue to earn stable returns.
As expected, even when interest rates are assumed to instantaneously rise 200 basis points, the stable value portfolio’s
MV/CV ratio quickly returns to a manageable level and
the crediting rate matches increases in interest rates over
time. While the stable value portfolio continues to generate
strong, consistent returns for the participant in all of the rate
scenarios, fixed income investments that don’t use investment contracts (unwrapped) would experience significant
losses based on the magnitude of the assumed increases in
interest rates.
While the scenarios in Figures 4 and 5 depict a clear
portrayal of how a stable value portfolio might perform if
rates instanteously increased dramatically, the assumption
used are intentionally simple, and as a result are not reflective of current expectations for future interest rates.
Figure 4 // Projected Contract Value Crediting
Rates in Rising Rate Scenarios
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
Year
1
Year
2
Year
3
No Change
Year
4
Year
5
Year
6
+50 bps
+100 bps
Year
7
Year
8
Year
9
Year
10
+200 bps
Figure 5 // Projected Surplus Deficit
3.0%
2.0%
1.0%
0.0%
-1.0%
-2.0%
-3.0%
-4.0%
Year 1
Year 2
Year 3
No Change
4.
Year 4
Year 5
+50 bps
Year 6
+100 bps
Year 7
Year 8
Year 9
Year 10
+200 bps
The hypothetical stable value portfolio characteristics: 15 year average of BarCap 1 to 5 GC duration and convexity, starting Yield to Maturity=Yield to Maturity at 12/31/2012.
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Projecting Stable Value Performance & Characteristics
In an effort to incorporate current market expectations into
the discussion of rising rates, we modeled the hypothetical
performance of a stable value fund using yield changes as
implied by the current forward Treasury yield curve. While
this analysis is simplistic in market assumptions, it provides
a reasonable scenario of expected changes in market interest
rates and how stable value could subsequently perform over
the next several years.
Figures 6 and 7 illustrate the projected contract value
performance of three model stable value portfolios. The first
model was assumed to start with a market value gain of
4%, the second 2% and the final model at parity (contract
value = market value). The graphs illustrate the expected
crediting rate behavior assuming interest rates follow the
implied forward Treasury curve. As all three models earned
the same projected market value return on the underlying
assets, they eventually begin to converge over time as gains
are amortized through the crediting rate reset process.
The model also assumed that the crediting rate formula
included a provision to accelerate loss amortization when the
MV/CV ratio reached a floor threshold of 98%. Amortizing
losses more rapidly based on the size of the market value
deficit is a relatively new provision that is designed to help
the portfolio achieve parity at a more rapid pace and is
included in a handful of stable value investment contract
agreements. As can be seen in Figure 6, when the loss acceleration provision is implemented, the credit rate declines
slightly, helping to limit the size of the market value deficit
and therefore shortening the time required to reach parity.
While Figures 6 and 7 only illustrate a five-year projection, if interest rates were assumed to stabilize then the three
models would move together towards parity over time, as
seen previously in Figure 5. The performance differences
between the models can be expected to gradually dissipate
reflecting the identical market value returns on the underlying assets.
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| Stable Value Perspectives . April 2013
Figure 6 // Projected Crediting Rate Behavior of Three
Model Stable Value Portfolios
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
Year 1
104%
102%
Year 2
Par
Market Yield
Year 3
104 (Unadj.)
Year 4
102 (Unadj.)
Year 5
Par (Unadj.)
As all three models earned the same projected market value return,
they begin to converge as losses are amoritized through the crediting
rate process.
Figure 7 // Projected Surplus Deficit
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%
-1.0%
-2.0%
-3.0%
Year 1
Year 2
104%
Year 3
102%
Par
Year 4
Year 5
Table 2 // Hypothetical Performance of Three Model Stable
Value Portfolios
Starting MV/CV
Period Return
104%
102%
SV CV Return SV CV Return
Par
SV CV Return
Unwrapped
MV Return
3 Month
0.51%
0.31%
0.11%
0.05%
6 Month
0.99%
0.61%
0.23%
0.08%
1 Year
1.87%
1.18%
0.49%
0.14%
3 Year
1.62%
1.15%
0.67%
0.15%
5 Year
1.66%
1.31%
0.94%
0.54%
% in Surplus
50%
37%
0%
N/A
Avg. MV/BV
100.4%
99.6%
98.8%
N/A
Table 2 illustrates the performance characteristics of the
three model portfolios. Not surprisingly, the model portfolio
with the 4% gain provided the highest contract value returns
and operated with a gain in 50% of the periods. While the
model that began at parity did not operate in a surplus during
the initial five years of assumed rising rates, the net crediting rate increased more than 240% from 0.45% to 1.55%.
All three models met the stable value objectives of providing
capital preservation and a stable and predictable crediting rate
that moved in the direction of market interest rates.
Conclusion
A decade ago it was highly unlikely that plan participants
would make inquiries about the underlying mechanics of a
stable value fund, as most were satisfied with relying on the
classification of stable value as a safe and conservative investment vehicle. The interest in understanding the mechanics
of stable value has increased markedly on the heels of the
financial crisis as plan sponsors seek reassurance regarding
the safety of their funds. It is important to understand that
the mere existence of a market value deficit is not a reason for
concern, and is in fact a normal part of the way a stable value
fund operates. With proper investment management, a stable
value fund can continue to thrive, even in a sharply rising rate
environment, meeting both the capital preservation and stable/
competitive return objectives.
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The scenario analysis shown in this paper is designed to provide a demonstration of stable value dynamics under highly simplified,
hypothetical market dynamics. The crediting rate is assumed to reset quarterly. Changes in rates are assumed to be parallel shifts; credit
spreads and prepayment speeds for asset backed securities are assumed to be constant at current rates; the model assumes no cash flows
into and out of the Fund. The scenarios presented do not provide a representation of our future expectations of risk free rates, credit spreads,
prepayment speeds, wrap fees, or participant cash flows. Many of the assumptions made are counter to both historical experience and expectations of future dynamics for the purpose of additional stress and simplicity. The scenarios represent passive management of the fund,
making no assumptions about Galliard Capital Management’s portfolio management response to various market environments.
Galliard is a specialist in stable value and
fixed income management and currently
manages more than $84.1 billion in assets
for institutional investors.
Galliard Capital Management
800 LaSalle Avenue, Suite 1100
Minneapolis, MN 55402-2054
800-717-1617
The information contained herein reflects the views of Galliard Capital Management, Inc. and sources believed to be reliable by Galliard as
of the date of publication. No representation or warranty is made concerning the accuracy of any data and there is no guarantee that any
projection, opinion, or forecast herein will be realized. The views expressed may change at any time subsequent to the date of publication.
This publication is for information purposes only; it is not investment advice or a recommendation for a particular security strategy or investment product. Graphs and tables are for illustrative purposes only. Galliard’s advisory fees are disclosed in the firm’s SEC ADV Part II which
is available upon request. Past performance is not an indication of how any investment will perform in the future.
FOR INSTITUTIONAL INVESTOR USE ONLY.
© 2013 Galliard Capital Management, Inc.
SVP032013