The Continuing Evolution of Stable Value Investing

The financial crisis of the past 18 months intensified with the collapse and/or bailout of some of the world's largest financial institutions, and then the multi-billion dollar bailout of the domestic auto industry. Inflammatory media coverage coupled with the receipt of quarterly participant asset statements, reflecting significant negative returns in many investment options, resulted in generalized risk aversion, thereby further aggravating the crisis. An auction of 30-day T-bills in November resulted in a yield of just 0.00% demonstrating just how risk averse the markets were, and the Fed Funds rate was reset on December 16, 2008 by the FOMC at a target range of 0.00% to 0.25% in an attempt to get credit flowing again. January and February of 2009 saw continuing declines in the equity markets albeit with some stability in the fixed income markets. Perhaps because the FOMC has not increased the target Fed Funds rate in subsequent meetings, the liquidity crisis seems to have abated somewhat. And happily March through July of 2009 has been a period of significant recovery in the equity markets, so perhaps we have seen the worst of it.

Since their inception 40 years ago, DC plan participants have relied on stable value to protect assets from risk of loss, to diversify their portfolios and to blunt the risk of higher volatility investments, while providing attractive returns significantly in excess of inflation and money market funds. Participants investing in stable value have been insulated from the anxiety of sudden changes in their retirement assets, as illustrated by the charts on page 5. FCM has always advocated a significant core allocation to a laddering strategy for all stable value portfolios. Laddering is a strategy of holding securities with equally spaced, comparably sized maturities designed to spread reinvestment risk out over an interest rate cycle. This results in a continuous stream of cash flow from maturities, which can be reinvested at then current yields. The maturity ladder also provides for managing portfolio duration and regular liquidity to satisfy participant withdrawal activity, reducing the need for an otherwise higher amount of liquidity reserve (cash equivalents) or for securities liquidation and its potential costs. Additionally, portfolios that demonstrate good liquidity management get preferential pricing from traditional GIC and synthetic GIC wrap issuers. Moreover, due to their long-term historic 0.34% average yield premium over the closest equivalent bonds, exceptionally low default rate and very high recovery in the unlikely event of default, FCM has always employed a higher allocation to traditional GICs than buy & hold wrapped bonds. In fact 22 years ago when FCM was founded, our portfolios employed nothing but GICs at a time when there were still over 50 different issuers. However, the universe of high quality GIC issuers has shrunk over time mostly through industry consolidation and especially in the past year as the credit-worthiness of some has softened to where they no longer meet our standards and as others, whose quality is still high, have withdrawn from the market. Happily, we have heard rumors recently of some high quality issuers entering or reentering the GIC market.

Most GIC contract rates do not change in response to market rates or credit levels. Therefore, the allocation of GICs was not subject to any principal or yield changes as a result of recent events. FCM constantly monitors each of the GIC issuing insurance companies as well as the bonds in our diversified portfolios. It is helpful to remember that the insurance industry is one of the most highly regulated financial industries in the world, the companies that issue GICs continue to demonstrate resilience in the face of these major market events, and GICs are policyholder obligations and therefore senior to all general creditors. Happily, credit downgrades by the rating agencies seem to have abated and there have been a growing number of affirmations.

Actively managed evergreen "synthetic GICs" and "separate account GICs", consisting of wrapped fixed income managed portfolios, offer industry and securities diversification, improved liquidity of the underlying securities and the potential for increased credit quality. Given the decrease in the number of high quality GIC issuers over the years and particularly over the past year, diversification into evergreens is now mandatory. But it is critical to employ fixed income managers for the evergreen allocation who have a demonstrated ability to outperform the unmanaged benchmark indices and to overcome the GIC yield advantage mentioned above, as well as the approximately 30-50 basis points of manager and wrap fees. In the long run, any bond portfolio will produce total returns equal to the income return on the underlying portfolio, plus (or minus) the value-added by the manager (alpha), since capital losses due to interest rate rises have to cancel out capital gains due to interest rate declines or else we would experience negative interest rates over time. In the absence of client preferences to the contrary, we had evolved from 100% GICs to where a year ago we would have invested approximately 30%-35% of the total stable value portfolio in two or more different, actively managed "evergreen" synthetic or separate account portfolios. That target allocation has now been moved to 45% in light of the shrinkage in the GIC universe. We select sub-advisors with distinctly different fixed income management styles, so that through style diversification we can achieve less volatility for the evergreen component in total than would otherwise be the case with just one sub-advisor.

Even though the yield on the underlying bond portfolio will rise when interest rates go up, the crediting rate on the wrap or separate account contract will lag current yields because it is impacted significantly by the capital losses on the underlying principal investment. And so all other things being equal, allocating relatively less new cash flow to "evergreens" until yields are demonstrably above the midpoint of at least the near term historic range of interest rates will minimize the amount of capital losses that are passed through via the wrap contract crediting rate formula. Many diversified pools of bonds have already been under pressure from recent market events and have experienced reductions in market values. If we go through an extended period of interest rate increases as many observers expect due to the magnitude of the deficits now being taken on in Washington, synthetic and separate account returns will soften for the foreseeable future. But diversification is vital to mitigating risk and therefore evergreens are nonetheless an important tool in conjunction with GICs, especially given the shrinkage in the universe of GIC issuers.

FCM employs a proprietary portfolio duration model that takes into account an historical look-back with which to compare the current level of interest yields in determining the appropriate duration target for the overall portfolio, rather than attempting to guess where yields may be in the future. The shape of the yield curve needs to be a consideration, but should be secondary to the level of interest rates relative to past history in making duration decisions. The cash portion of the fund is invested in a money market type fund, or to use bank jargon a STIF (short term investment fund), whose rate changes daily. STIF yields have declined to as low as 0.25% to about 1.00%, so any excess cash can be a drag on performance. The portfolio manager follows an evolving investment process where decisions are based on the credit quality and the relative value offered by all available stable value investments. Recent events have shown that there are no perfect guarantees anywhere, but FCM remains comfortable with our analysis of the financial landscape, the investment evolution, and the appropriateness of stable value over other relatively low volatility investment alternatives, as illustrated by the charts found on this website.