The Downside of Up for Stable Value Funds

There are three sets of hike and bike trails along the bayou near my home. Lest you think this statement a bit ostentatious I should point out that these trails follow the large drainage ditch that is affectionately known as a bayou in my neck of the woods.

Trail #1 is paved and serves as the conduit for spandex-clad individuals who want the illusion of the Tour de France minus the requisite training, or the Alps. With the exception of a close encounter with a Lance Armstrong devotee, this is a fairly safe, uneventful trail.

Trail #2 mirrors the first but is unpaved and sits above the berm that theoretically keeps the adjacent neighborhoods from a close encounter with the bayou. Trail #2 does have an occasional bout of elevation and a stray rock or two, but the main danger comes in the form of unattended proof of prior dog walks.

Trail #3 actually winds within the banks of the bayou. It twists and dives, choked with vegetation and mosquitoes. Portions of Trail #3 are frequently washed away when the bayou floods. In short, Trail #3 is a lot of fun for the mountain bike enthusiast – until it’s not.

While this description might mistakenly give the impression that a huge range exists in the risk levels of these three trails, the reality is that even Trail #3 can be successfully navigated by a rank amateur or weekend warrior. It takes longer and likely involves a few more bumps and scratches but is not something that someone who hails from a state with actual mountains, even hills, would think twice about.

If we juxtapose our trails against the financial world, I submit that Trail #1 is a lot like a money market fund: no cliffs, no impending rock slides, and a smooth, predictable surface.

Stable value funds, on the other hand, historically resemble Trail #3. Unlike money market funds, they invest in intermediate-term bonds that have a fair amount of play in their market value. Some stable value funds have also placed small amounts in sub-prime and even high yield bonds. We have already had a more detailed comparison of money market and stable value funds in other forums so we will forego repeating that information here.

I take Trail #3 on days that I’m looking for a little more excitement – more return on my investment. I take Trail #1 on the days my four-year-old wants to accompany me on his bike (a different kind of return altogether). Neither of these trails has the thrill or danger involved with, say, riding on the city streets in my car-friendly town, but it’s nice to have options.

Options are unfortunately something the stable value community may have quite a bit less of in our post-2008 financial meltdown world. The market upheaval has rattled the insurers that provide “wrap coverage” on the bond portfolios within stable value funds — smoothing out the rough spots and solidifying the fund’s ability to maintain a stable value.

These insurers are so rattled that, in most cases, they have stopped issuing wrap coverage. Stable value managers continue to receive new contributions but don’t have the ability to build new bond portfolios with wrap coverage as a stabilizer. Many stable value managers have resorted to putting new contributions in money market funds while they attempt to negotiate other options from the insurance community.

Most of the stable value managers I’ve spoken with feel that the insurers will one day soon overcome their reluctance and begin to offer wrap insurance once again (ironically it does not appear that any of these insurers suffered a claim based on their existing coverage, so their fear may be largely in their own minds). It’s important to note that when the insurers do begin to write coverage again they will likely eliminate the stable value manager’s ability to invest in the riskier portions of the bond market. In short: the insurers will be far more interested in investments that look like Trail #1 versus Trail #3.

With all of that as a backdrop, let’s look again at the objective of a stable value fund: a higher return while maintaining a stable net asset value with a little more risk than a money market fund.

Historically, stable value funds have been able to offer somewhere in the range of 1.0 – 1.5% higher returns than a typical money market fund over a 5 – 10 year period. This, like Trail #3, is not an overly dramatic difference, but in a world where the five-year return of a given money market fund is 3%, it’s nice to have an option that may deliver 4.5%.

It now appears that Trail #3 faces several roadblocks:

  • Reluctance of insurers to write new wrap coverage
  • Higher rates on existing wrap coverage
  • Restrictions on the risk profiles of the bond portfolios
  • Build up of large cash positions within stable value funds

I think it’s fair to say that, barring a dramatic change of heart on the part of the insurers, significant portions of Trail #3 will be closed for the foreseeable future. The stable value ride will instead resemble the somewhat ho-hum thrill and return level of Trail #2.

For investors and plan sponsors, this situation is worth pondering. When the potential upside of a stable value fund was 1.5%, it was easier to justify the complexity of the investment and the fact that the assets in this investment could be held for up to a year before pay out if the 401(k) plan removed it as a menu option (known as the “12 month put”). If this upside has truly shrunk to something more like .50 – .75%, then many folks out there might prefer the plain, smooth ride of Trail #1 and money market funds.

In either event, based on the 2008 experience a helmet is probably a good idea.

*Originally published November, 2009