An Update on the Continuing Evolution of Stable Value Investing

Since the inception of what is now called stable value over 40 years ago, DC plan participants have relied on stable value funds to protect their assets from risk of loss, to diversify their portfolios and to blunt the risk of higher volatility investments. Stable value has provided attractive returns significantly in excess of inflation and money market funds, as illustrated by the charts on page 5, showing the performance experienced by FCM's clients and their participants. However, the financial crisis that began about two years or so ago has had a dramatic impact on stable value investing in a variety of ways. 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 and has remained there ever since. Unfortunately there has been only a modest increase in credit availability, so all interest rates have remained near historic lows for an extended period, albeit with credit spreads over treasuries gyrating significantly from one period to the next.

Due to their long-term historic 0.36% average yield premium over the closest equivalent bonds as illustrated in the chart below, exceptionally low default rate and very high recovery in the historically unlikely event of default, FCM has always employed a higher allocation to traditional GICs than wrapped bonds.

23 years ago when FCM was founded, our portfolios employed nothing but traditional 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 two plus years 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of some has softened to where they no longer meet our standards and as others, whose quality is still high, have withdrawn from the market, hopefully temporarily. Happily, one high quality issuer that had withdrawn from the market has recently re-entered and we have heard rumors of several others. As of this writing, there are about 7 high quality active issuers of traditional GICs. Happily, credit downgrades by the rating agencies have abated and there have been a growing number of affirmations, although no upgrades as yet.

In the long run, any bond portfolio will produce total returns before fees equal to the income return on the underlying portfolio, plus (or minus) the value-added (or detracted) 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. Therefore, the GIC allocation would be expected to outperform a fixed income allocation of similar quality and duration. Nonetheless, given the decrease in the number of high quality traditional GIC issuers over the years and particularly over the past two and a half years, diversification into actively managed evergreen "synthetic GICs" and "separate account GICs", consisting of wrapped fixed income managed portfolios, is mandatory. We had evolved from 100% traditional GICs in 1987 when FCM was founded to where 2-3 years ago we would have invested approximately 30%-35% of the total stable value portfolio in two or more different, actively managed internally diversified "evergreen" synthetic or separate account portfolios. That target allocation has now been moved to 50%, in light of the further shrinkage in the traditional GIC universe and the resulting difficulty of achieving sufficient issuer diversification even after taking into account legacy holdings of issuers that are no longer active.

Industry-wide there is currently a severe strain on the capacity available for new synthetic stand-alone wrap contracts. In fact there is currently just one issuer with limited ability to accept deposits of what might be termed traditional evergreen synthetics. However, there are as many as 6 and soon 7 issuers of insurance company synthetic/separate account contracts currently active to fill this need. These products are somewhat different from the "traditional" wrap structure in that the insurance company that provides the wrap generally also manages the underlying assets either directly or through an investment management subsidiary. Depending upon the company, their insurance company synthetic/separate account contract may be available as a separately managed portfolio or commingled fund with lower minimums and may also be available with the assets held in a trust account vs. an insurance company account held separate from the insurance company's general account assets. In total, there are currently at least 17 different internally diversified investment strategies from which we may be able to choose. As mentioned above, we believe that it makes sense to achieve some investment style diversification, and so we would want to see at least two distinctively different investment styles represented within the Evergreen Allocation. No matter what their form, the evergreens all do the same job of providing book value treatment to participants and smoothing the volatility of the underlying fixed income assets while crediting no less than a zero rate of return.

With interest rates as low as they are, we are currently focusing our attention on relatively shorter duration strategies to insulate the wrap crediting rate from the need to amortize capital losses on the underlying principal investment when interest rates inevitably rise from their current historic lows. Therefore all other things being equal, we would prefer to allocate 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 to minimize the lag effect on their crediting rate. But diversification is vital to mitigating risk and therefore evergreens are nonetheless an important tool even now in light of the shrunken universe of traditional GICs.

FCM investment decisions are based on the credit quality, risk, and relative value offered by all available stable value investment vehicles. Events over the past 2-3 years have provided challenges and have necessitated a continuation in the evolution of stable value, but we remain convinced of the appropriateness of stable value over other relatively low volatility investment alternatives.