Stable value funds (SVF) are typically short- to intermediate-term, high-quality, fixed income bond funds. They represent a low-risk source of diversification in a fund lineup for retirement plans and are considered a fixed income alternative to money market funds and bond mutual funds. SVF are deemed a good alternative to bond mutual funds because of their investment objective to seek stable returns across various economic and interest rate environments. They are an alternative to money market funds because they typically offer higher credited rates and relatively lower risk compared with other investments generally.
How can the returns be stable AND be higher than money market fund yields through rate cycles?
The “funds” are “wrapped” with contracts issued by banks or insurance companies that help smooth out the returns of the underlying portfolio of bonds. Losses and gains of the underlying investments are spread over the duration of the fund. The investment objective of SVF is to provide capital preservation and predictable, steady returns via the credited rate smoothing mechanism.
Today, investors may be hesitant to allocate to SVF relative to equities. It’s not surprising following a year when the S&P 500 returned in excess of 30%, the Barclay’s Aggregate Index returned negative -2.0 percent, and SVF credited rates ranged between 0.3 percent and 2.1 percent. However, this is comparing apples to oranges.
What’s relevant is comparing SVF to money market and bond mutual funds. It is equally important to remain committed to the principles and benefits of diversification, being mindful of unique age and income-based needs. Most investors should diversify across a broad range of asset classes, holding portfolios that include stocks and bonds as well as low-risk investment choices like SVF. Quantifying the impact of diversification through market cycles highlights the potential benefits, with 2008 representing a worst-case scenario for many portfolios that held a significant equity concentration.
What I get asked most often is, when are crediting rates going to increase … meaningfully?
We believe there may be a gradual upward movement in interest rates as the underlying strength developing in the U.S. economy flows into higher real growth this year. Household net worth has largely recovered, quality of consumer and corporate balance sheets has improved significantly, and gains in real GDP inputs are solid, so it is our opinion that real growth has upside potential relative to forecasts.
Because corporate balance sheets are healthy, because consumers have deleveraged, and because there is increasing access to credit, I believe real demand will support higher-than-expected growth in 2014. Offsetting higher interest rates is a tighter spread environment, so that increasing earned rates in a portfolio will be a very gradual outcome of rising Treasury rates. The composition of SVF, as well as cash flow generated from the SVF that will participate in a rising rate environment, are factors that also determine credited rate movements.
Why SVF today?
An investor nearing retirement or in retirement may want to preserve principal and minimize risk. SVF may be more appealing to this type of investor for several reasons. Management fees for SVF are typically less expensive than those of bond mutual funds, SVF can be used as a low-risk tool to diversify overall portfolio risk, and credited rates typically do not fall below 0 percent. The SVF crediting rate smoothing formula relative to the actual return earned on a bond mutual fund, which can be negative in a rising interest rate environment, may also be more appealing for these types of investors.
In a rising rate environment, managing duration exposure and cash flow reinvestment is critical to performance. With an improving economy as a backdrop, the Federal Reserve Board taper program underway and the Fed Funds rate expected to increase in 2015, opportunities to increase yield and SVF credited rates will grow. Current positioning is important so that cash and SVF cash flows can be targeted to these opportunities, participate in the higher rate environment, and grow asset balances over time.