The Relative Value of GICs: "Show Me the Spread"

Throughout the latter part of our nineteen-year history, FCM has maintained above average allocations to traditional guaranteed investment contracts (GICs) issued by major life insurance companies within our stable value portfolios. We have found several advantages in using GICs over other stable value products including the following: policyholder/senior claims status, built in benefit responsiveness, individually tailored cash flows, no embedded options, no broker commissions, and an inefficient market place resulting in advantageous risk/return opportunities. Nonetheless, when it comes to the investment decision making process one has to focus on what we consider to be one of the most important advantages of GICs: Relative Value. The term "relative value" can be loosely defined as the ranking of fixed-income investments by sectors, structures, issuers, and issues in terms of their expected performance during some future time horizon.

During the investment decision-making process, FCM evaluates various segments of high investment grade bond market on a nominal and option adjusted spread (OAS) basis in order to identify relative value opportunities. When evaluating appropriateness of investments for stable value portfolios, a manager should consider several factors including credit quality, cash flow volatility, liquidity, and benefit responsiveness.

Based on these factors, the characteristics of the GIC market can be best compared to AA rated corporate bonds that are wrapped to provide for benefit responsiveness. Exhibit 1 illustrates the excess yield or spread over similar duration Treasuries for the Average 5yr GIC Contract, the High 5yr GIC Contract, and 5yr AA Corporate Bonds net of wrap fees based on a FCM study looking back to early 2002. As illustrated, GICs have historically provided solid spreads over comparable AA bonds with the average 5yr GIC contract typically offering around 10 to 20 bps, while the high 5yr GIC has offered close to 40 bps on average over the time period of the study. Moreover, although we are sometimes able to buy the high GIC, FCM's actual GIC purchases after taking into account diversification needs have historically been at yields somewhere between the average GIC offering and the high GIC offering. Based on that fact, we have calculated the FCM 5yr GIC/AA Spread as the average of the excess spreads over AA corporates for the High GIC offering and the Average GIC offering. Over the period of the study, the FCM 5yr GIC/AA spread has averaged 27 bps, a value opportunity that has consistently enhanced the relative performance of FCM's stable value portfolios. Moreover, we feel that this spread more than compensates for a lack of liquidity in GICs given their private placement nature compared to publicly traded corporate bonds.

Over the last year, the excess spread of GICs over AA bonds has narrowed to well below the longer-term averages with the FCM 5yr GIC/AA spread averaging 12 bps over the last six months. This can best be explained by current conditions within the fixed income markets that have resulted in historically tight spreads across the credit spectrum. From the insurance company perspective, the GIC business is a spread business with profitability tied to the difference between yields on invested assets and interest credited to the GIC holder. Moreover, companies issue GICs based on their financial strength ratings (typically AA or better) and invest these proceeds into segments of their general accounts comprised of lower rated investments including BBB rated public and privately issued corporate bonds and to a lesser degree commercial mortgages. As shown in Exhibit 2, the spread between AA and BBB bonds has declined over the past few years to historically low levels. This has resulted from the very favorable credit cycle with historically low levels of defaults and increased investor appetite for risk in the search of higher yields. Tighter credit spreads have translated into lower returns on new GIC business for insurance companies, which has resulted in lower capital allocations to the business and less aggressive pricing. As a result, the FCM 5yr GIC/AA Spread has also contracted to historically low levels, as illustrated in Exhibit 2. That said, GIC spreads have held up very well compared to AA bonds even in the current relatively difficult environment and are expected improve once market conditions normalize.

In conclusion, compared to the other investment vehicles available to FCM, GICs have offered significant relative value and have made a material contribution to our consistently superior performance record mentioned elsewhere in this newsletter.

EXHIBIT 1