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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 2 | 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. www.galliard.com | 3 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. 4 | 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. www.galliard.com | 5 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. 6 | 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. www.galliard.com | 7 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