Diversification is the Key
Peter E. Bowles, President and CIO

Just as in both equity and conventional fixed income investing, we have been reminded in recent months that diversification is also very important in stable value investing. In early January, one of our clients contacted us to ask what was so different about their stable value fund that had protected them from the problems they had been hearing about in other stable value funds. Then in the January 26, 2009 issue of Pensions & Investments, there was an article about State Street Corp. adding $610 million to their stable value funds and purchasing about $2.5 billion in risky securities from their $13.9 billion of stable value funds under management in order to stabilize their crediting rates. Although stable value generally has weathered the continuing financial storm better than other asset classes, it does appear from these reports that some stable value funds have fared relatively less well than others. For example, although traditional GICs generally seem to be holding their own, some evergreen synthetic GIC portfolios within certain plans' stable value funds have had significant problems, resulting in dramatic drops in crediting rates. And some of the assets wrapped in some "buy & hold" synthetic GIC allocations have also run into trouble.

Traditional GICs are essentially individually negotiated private placement bonds issued by high quality life insurance companies. The vast majority of GIC issuers have earned at least one AA or higher agency rating. Their credit worthiness is the claims paying ability of the issuing insurance company as a going concern. And, as policyholder obligations, GICs are senior to all general creditors and of course equity holders for stock vs. mutual insurance companies. The state regulators for this very closely regulated industry are dedicated to preserving value for policyholders of all kinds and many states have established state guaranty funds that provide an extra layer of protection for their states' policyholders, including GIC holders, in addition to the insurance companies' own assets. During the entire nearly 40-year history of the GIC asset class, there have been only four defaults and three of the four ended up paying out at least 100 cents for every dollar of principal invested in the defaulted GIC. Even the worst case, Executive Life, paid out over 92 cents in stark contrast with the average defaulted publicly traded bond where recovery has been only about 43 cents for every dollar invested, according to Moody's. In addition, for most traditional GICs "what you see is what you get". In other words, there is no optionality imbedded in the contract and GICs cannot extend or prepay, unlike many conventional publicly traded bonds, especially the mortgage related securities.

So why have plans gravitated toward both buy & hold and the evergreen "synthetic GICs" in recent years? Unfortunately, traditional GICs are now issued by very few insurance companies, only about a dozen or so on a good day. And so in addition to the need for some diversification outside of the insurance industry, it is not possible to get as much individual issuer diversification with only 12 or so traditional GICs, as is possible with a conventional bond portfolio. And they cannot realistically be publicly traded, so traditional GICs are not very liquid except for participant directed benefit and transfer payments, where they are fully liquid usually on a daily basis. So plans began using "synthetic GICs" about 15 or so years ago, initially in addition to traditional GICs and today sometimes to the exclusion of traditional GICs. Unfortunately, over the past six months or so many of the securities inside the synthetic GIC structures proved not to be as liquid as previously thought.

A "synthetic GIC" consists of two parts, a conventional publicly traded fixed income security or an entire portfolio of fixed income securities and a separate wrapper contract issued by an insurance company or bank. The plan actually owns the underlying fixed income securities and the wrapper contract provides an accounting mechanism to provide book value accounting by smoothing the market value gains and losses on the underlying securities. The crediting rate on the wrapper contract that is reported to participants usually starts out as the yield to maturity of the underlying assets and then each calendar quarter the bank or insurance company wrapper looks back to see how much gain or loss there has been and then adjusts the crediting rate for the subsequent quarter up or down to amortize the gain or loss on the securities, promising never to credit less than zero. Everything progresses uneventfully unless the underlying fixed income securities experience such dramatic losses that the bank or insurance company loses confidence that the loss may not be able to be regained over the amortization period, which is typically the duration of the underlying assets. If this happens, the bank or insurance company will continue to credit zero or higher to the contract, but will drop the crediting rate substantially and may even invoke it's contractual right to protect it's interest by requiring that the underlying portfolio be liquidated and invested in Treasuries and/or agencies.

Doing so will limit any credit risk, and they may require that the actively managed portfolio be converted into an immunized portfolio with a target maturity date. The bank or insurance company may even require that additional assets be added to the wrapped portfolio if they do not believe that they will otherwise have recovered the entire loss by the time the target maturity date has been reached. Obviously, any of these actions will depress the blended rate on the stable value portfolio being reported to participants and generate distress.

The past six months were an especially challenging period for fixed income managers with all of the extreme turmoil in the financial and credit markets. As a result, some heretofore very successful fixed income investment managers stumbled badly. The key to those evergreen synthetic GIC managers who had relative success in the recent past was a greater concentration on Treasuries and Agencies since interest rates on these securities declined significantly since there has been a flight to quality resulting in a significant widening of credit spreads. But Treasuries and Agencies offer lower yields over time of course even during the best of times, so the return on their clients' stable value funds would be depressed if they were the only securities they ever bought. Consequently, most evergreen synthetic managers historically invested in a variety of fixed income securities in addition to Treasuries and agencies. Their investments included corporate bonds and the mortgage backed securities that have been especially hard hit. Consequently, some stable value funds have suffered quite dramatic drops in crediting rates as the market values of the underlying assets diverged sharply from the book values being reported by the wrapper.

What the recent past has once again demonstrated is the great value to diversification of every sort: diversification among asset types including GICs, evergreens and buy & holds, diversification within the asset types so that not too much is invested in any individual GIC issuer or evergreen manager or wrap writer, and diversification by investment style so that multiple evergreen managers are managing the assets assigned to them in significantly different ways, employing different investment philosophies. As a result of FCM's management of managers approach, FCM's clients' portfolios are unusually well diversified in all of the ways suggested above. Since none of us can consistently foretell the future with any accuracy and none of us know where the next problem may arise, or for that matter where the next opportunity may be, it is best not to "have too many eggs all in the same basket", so diversification is the key.