In general, underlying portfolio performance was weak during the most recent quarter due to a sell-off in many of the fixed income markets, according to Blue Prairie Group’s (BPG) Stable Value Database Executive Summary. The data shows this downward movement in performance has been occurring over the last six quarters or so, mostly due to the sustained low interest rate environment.
Performance of the underlying portfolios in the third quarter of 2013 over a one-year trailing period ranged from 0.19% to 2.68%, with an average return of 1.71%. Over a trailing three-year annualized period, the range was 1.43% to 3.65%, with an average return of 2.43%. The wide performance dispersion stems from the significant performance differences in separate account products, which tended to have much longer durations, and synthetic products, with shorter durations, BPG explains. Rolling returns continued their descent in third quarter.
In the second quarter of the year, the stable value marketplace saw a dramatic downturn in market-to-book ratio due to a widespread sell-off of bonds. This sell-off was instigated by the Fed’s “tapering” talk, and caused bond prices to decrease significantly. Ratios have recently begun to rebound, with the average increasing from 101.29% in the second quarter to 101.44% in the third quarter. For the second consecutive quarter, however, some funds in BPG’s database reported market-to-book ratios below 100%.
As forecasted by BPG, crediting rates continued to drop in the third quarter of 2013. The data shows the average crediting rate has fallen over each of the past 10 quarters—plummeting from 3.07% in Q2 2011 to 1.78% at the end of Q3 2013.
BPG believes crediting rates will continue to fall for the following reasons:
- Rates on short-duration, high-quality fixed income instruments are low and will continue to be so for the near future; and
- With wrap providers instituting tighter investment restrictions, more managers are holding higher credit quality portfolios, as well as unwrapped cash reserves for the short end of their portfolios, which are yielding almost nothing.
BPG notes that the volume, timing, and direction of cash flows in and out of the fund can significantly affect crediting rates, as the manager may be forced to buy and sell securities at inopportune times.
Over the last few quarters, stable value fund managers have generally increased their allocations to treasuries and high quality corporate bonds. Managers again in the third quarter of 2013 reduced their cash allocations and increased their treasury, mortgage-backed security, and traditional guaranteed income contract (GIC) allocations.
Portfolio allocations differ dramatically by product type. For example, synthetic GICs averaged 18.42% in corporate bonds and 12.39% in agency pass through mortgage-backed securities, while separate account GICs averaged 34.70% and 30.65% respectively.
The reported expense ratios for the funds tracked in the database ranged from 10 to 67 bps. This reflects the lowest share class offered by the provider, and may or may not have included certain costs, such as wrap fees (depending on the reporting policy of the provider). Wrap fees range from 15 to 25 basis points, and averaged approximately 20 bps.
Following lessons learned from the 2008 economic crisis, the stable value industry has made changes improving stable value offerings (see “Stable Value Deserves Reconsideration”).
According to the BPG Stable Value Database Executive Summary, wrap providers are actively taking steps to reduce their risk in underwriting a stable value portfolio. They have done this by requiring fund managers to follow more conservative investment guidelines or by requiring that they manage the assets themselves in the form of a separate account structure or an externally managed “synthetic sleeve.”
The permissible portfolio durations are now shorter for funds with multiple wrappers, with only short or intermediate mandates allowed. Additionally, a larger percentage of assets are now required to be held in higher rated securities than compared to pre 2007. There are tighter sector limits for corporate and securitized debt product. Portfolios are now required to have higher overall portfolio credit ratings than they were previously, and mortgage-backed and consumer loan-backed bonds are now required to have AAA-ratings from multiple rating agencies.
Contract terms are more conservative and there is a greater level of specificity. Wrap providers are using stricter definitions of “competing funds.” Typically this has meant brokerage windows, money market funds, and short-term bond funds with an average duration of three years or less. This list has also expanded to include treasury inflation-protected securities (TIPS) funds as well.
There are greater restrictions on allowing stable value managers to hold “impaired assets” in the portfolio. Portfolios have higher allocations to U.S. Treasury and Agency bonds as sources of liquidity in the event of large cash withdrawals. Compliance reporting requirements dictated by the wrap providers have increased.
The BPG report offers a series of questions plan sponsors can ask their current stable value providers to get a good sense of whether their current stable value funds are competitive or not across a number of important product design dimensions.
The report is available at http://www.blueprairiegroup.com/stable-value/.
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