Stable value funds have thus far lived up to their name during the cataclysmic year that has been 2008. This is, without a doubt, a good thing.

As we have previously discussed in a recent article entitled “What is a Stable Value Fund?”, stable value funds are invested primarily in the bond market and therefore take more risk than a money market fund. More risk generally equates to more return in the long haul. It also means more volatility in the short-term. Does that mean that your stable value fund is about to become more volatile?

I’m glad you asked.

Any question involving the financial markets has a complicated answer that’s been made even more complicated by the events of the past 12-18 months. That said, we can at least attempt to point out some of the more obvious elements of the answer with the hope that you can use the information to your advantage in future discussions with the manager of your stable value fund.

Here are a few key elements of the traditional risks involved with stable value funds and the most recent wrinkles. Please keep in mind that these are very general concepts and the details for your particular fund may well vary.

Generally Accepted Fact (GAF) #1: when interest rates fall the value of existing bonds rises.

Typical Impact on Stable Value funds: falling interest rates typically trigger a significant increase in the current interest paid by stable value funds due to the rising value of the underlying bond portfolio.

Actual Impact on Stable Value funds in 2008: GAF #1 has failed us somewhat as the decline in interest rates has been accompanied by an even greater decline in trust when it comes to corporate bonds. To put it another way, those buying bonds as of late only want bonds backed by the federal government – corporate bonds have lost a significant amount of value because there are substantially fewer buyers.

Generally Accepted Fact (GAF) #2: stable value funds utilize insurance coverage (called “wrappers”) to smooth out the peaks and valleys in bond prices/yields. This is the majority of the reason that they are marketed as funds with a stable net asset value.

Typical Impact on Stable Value funds: the cost of the insurance wrap coverage is netted from the rate being paid by the fund. A typical stable value fund will utilize a number of different insurance companies to offset the risk of having all of their insurance eggs in one basket.

Actual Impact on Stable Value funds in 2008: GAF #2 is alive and well for the most part but the plot has thickened. You will recall that one of the largest insurance carriers – AIG – would now be bankrupt if not for the fact that we as tax payers have opened a very favorable line of credit to AIG in excess of $100 billion. AIG was a significant player in nearly all aspects of the insurance industry, including insurance wrap coverage for stable value funds. Their predicament has taken them out of this market which leaves fewer providers of insurance wrappers. Fewer providers in a time of greater risk generally means that those insurers still remaining will likely demand significantly higher premiums for the same coverage.

Generally Accepted Fact (GAF) #3: cash flow is one of the largest drivers of performance within a stable value fund.

Typical Impact on Stable Value funds: A large influx of cash in a declining interest rate market (when bond prices are high) forces stable value managers to buy bonds at inflated values – eventually bringing down the rate paid by the fund. The opposite is also true.

Actual Impact on Stable Value funds in 2008: GAF #3 is probably the single most important element of your stable value fund. The net flow – positive or negative – of your fund will likely have the biggest impact on your return and the overall health of the fund. We have the added complication of a bond market that isn’t responding to rate cuts (see GAF #1) in a traditional way BUT has instead inflated the value of any government-backed bond to the point where the yield-to-maturity is almost equal to burying the money in your yard.

Another way to think about this is that a stable value fund that has over weighted government-backed bonds has likely had a significant increase in market value (leading to higher rates). That’s wonderful in the near term. However, if this same fund attracts many new investors because of its high current rates, it will eventually suffer as all the new money being received has to be put to work in the bond market. Unless the fund reduces the amount it places in government-backed bonds, the same thing that drove rates up will drive them back down as the high priced government-backed offerings will offer little in the way of returns for the foreseeable future.

I mentioned up front that 2008 has made complicated things even more complicated, and I fear that the same is true for this article. It’s not my intent to make you manage a stable value fund but I do hope that these basic principles will help you ask timely questions of your stable value fund manager.

All of this may make you pine for the good old days when a money market fund was your only option in this area. If it makes you feel any better even money market funds have become complicated in the wrecking ball of a year that is 2008.

*Originally published in December of 2008