The first half of 2020 was good for stable value funds. According to data supplied by the Stable Value Investment Association (SVIA), stable value funds’ assets under management increased by about $60 billion during the first and second quarters, representing 7% growth since the second quarter of 2019. By the end of this year’s first quarter, stable value funds accounted for over 10% of the U.S. defined contribution market, according to the Investment Company Institute.
It’s likely that this year’s growth is partly attributable to the equity markets’ volatile pullback in the first quarter, but the funds’ steady returns were another factor in their favor. The SVIA reported that: “Stable value crediting rates (which are their annualized rates of return) averaged 2.37% (before investment management fees) across all types of stable value funds as of June 30, 2020, which represents a significant return advantage over short-term investments in the current low interest rate environment. Credit quality ratings averaged AA- and the average duration was 3.59 years across all fund types as of the end of Q2 2020.”
A Changing Market
Independent research confirms that the stable value market is healthy. A recent report from Nroop Bhavsar, CFA, a research analyst in Portfolio Evaluation, Inc.’s investment research group, “Observations on the Current State of Stable Value Funds,” determined that the stable value industry is in good shape, although the product mix is changing.
In emailed comments, Bhavsar noted that synthetic wraps’ fees have found an equilibrium “between 15-20 basis points as opposed to what we observed immediately prior and after the global financial crisis in 2008. Pretty much all stable value funds we have spoken to have ample wrap capacity even with COVID-19 pandemic-related market volatility. All these have led to a healthy state of stable value industry.”
The second type of stable value fund, guaranteed investment contracts (GICs), which are issued by insurance companies and part of the insurer’s general account, are losing market share, however. “With equilibrium on the synthetic wrap side, traditional GICs are gradually going out of favor,” says Bhavsar. “For example, average fund exposure to traditional GICs in 2011 was about 15%, which has dropped to about 6% as of June 30, 2020.”
Stable value providers, and the wrap providers who insure the book value of the portfolio, have a constructive relationship nowadays that has produced a strong and sustainable set of stable value solutions in the market, according to David O’Meara, director, investments with Willis Towers Watson. “Two key drivers of today’s stable value market are: 1) There is an understanding of and commitment to the wrap business by the wrap providers, leading to a robust wrap market, and 2) The investment guidelines of the underlying portfolios have loosed somewhat after becoming overly restrictive after the financial crisis,” O’Meara observes.
Bhavsar highlights two key trends his firm has been observing. The first relates to narrowing dispersion in market-to-book (M/B) ratios and in crediting rates. Following the global financial crisis, several contract terms were updated and renegotiated, so the capital preservation objective of stable value funds prevails. High yield bonds, private label mortgages and other risky securities that are deemed inappropriate for stable value portfolios are not allowed any more, he explains. These changes led to somewhat homogenous portfolio positioning; consequently, market movement impacts the funds similarly. The dispersion in M/B ratio narrowed over the years, resulting in similar narrowing dispersion in crediting rates as they are driven by market-value gain and loss.
The second trend is a shift from Treasurys and securitized assets to investment-grade corporate debt due to persistent low yields. Bhavsar points out that following the global financial crisis, fund managers began seeking higher yields without compromising much on quality. Gradually, the dynamics of the investment-grade corporate bond sector have shifted toward more allocation to BBB-rated credits, which is the lowest rated bucket for investment-grade credits as more companies took advantage of cheap debt. He notes that numerous household corporate names are BBB-rated and are part of many stable value funds.
Navigating Persistently Low Rates
Lower rates appear to be here for the foreseeable future and this environment benefits stable value funds, Bhavsar maintains: “The lower-for longer interest rate scenario is a new normal which makes short-term rates anchored. This is beneficial for stable value with regards to volatility and interest-rate risk given their short-duration profile. Fed support, a rebounding economy, and record corporate issuance have provided good buying opportunities this year.”
A comparison of historical returns indicates that stable value funds offer better income and yield opportunities than money market funds in a lower interest rate environment. “For example, stable value funds have outperformed money market funds on average by 188 bps (about 1.9%) on a rolling 5-year basis since 1999,” he adds. “This premium was much higher during low interest rate environments.”
O’Meara notes that many plan sponsors turned away from stable value during the financial crisis and haven’t gone back. The challenges that emerged during the financial crisis caused many plans to opt for as conservative a capital preservation option as possible. “With the evolution in the stable value market, and likelihood of extremely low future money market fund returns, plan sponsors should consider whether such a conservative position is in their participants’ best interest,” he says. “As such, we are seeing some clients be willing to revisit their capital preservation option.”