What Goes Around Comes Around

Skinny ties were once the "in" thing for men to wear with their navy blue pinstripe business suits. I still have some of both in my closet. And when FCM was founded twenty four years ago, our stable value portfolios employed nothing but traditional GICs at a time when there were still well over 50 different issuers. However, the universe of high quality GIC issuers has shrunk over time mostly through industry consolidation and also in the past several 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of some has softened to where they no longer meet our standards and as others, whose quality is still high, have withdrawn from the market, hopefully temporarily. Happily, two high quality issuers that had withdrawn from the traditional GIC market have re-entered and we have heard rumors of several others. Wholesale credit

downgrades of insurance companies by the rating agencies ended about a year ago and there have been a growing number of affirmations. But with the ongoing bickering in Washington over the debt ceiling/deficit reduction and the risk of a U.S. debt credit downgrade, we have some apprehension that there may be fallout on the credit ratings of some financial institutions as well. Time will tell.

Given the decrease in the number of high quality traditional GIC issuers over the years, diversification into actively managed evergreen "synthetic GICs" and "separate account GICs", consisting of wrapped fixed income managed portfolios, is mandatory. But due to traditional GICs' long-term historic 0.34% average yield premium over the closest equivalent bonds, 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 in stark contrast to most of our competitors. Nonetheless, we had evolved from 100% traditional GICs in 1987 when FCM was founded to where 3-4 years ago we would have invested approximately 30%-35% of a new client's 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 in the wake of the financial crisis and the resulting difficulty of achieving sufficient issuer diversification even after taking into account legacy holdings of issuers that are not currently active.

Industry-wide there is a severe and continuing strain on the capacity available for new synthetic stand-alone wrap contracts. All of the large banks that had been active in this market have pulled in their horns, none of them are issuing new contracts and in fact there is currently just one insurance company wrap contract issuer with limited ability to accept deposits of what might be termed traditional evergreen synthetics. However, there are as many as 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 a 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 25 different internally diversified investment strategies from which we may be able to choose. 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, synthetic or separate account, the evergreens all do the same job of providing book value treatment to participants and smoothing the volatility of the value of the underlying fixed income assets while crediting no less than a zero rate of return.

Interestingly, over the years most of our competitors had gotten away from employing either traditional GICs or insurance company synthetic/separate account contracts preferring instead to wrap their own internal bond management with a wrap contract issued by a bank. Since the banks have withdrawn from the stable value market, our competitors are now having to relearn skills, which they had long since abandoned, in order to buy insurance company products. And with interest rates as low as they are, we and other stable value managers are currently focusing our attention on traditional GICs, and on relatively shorter duration evergreen strategies to insulate the wrap crediting rate from the need to amortize capital losses on the underlying principal investments 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 evergreen crediting rates. Consequently, we and many of our competitors are allocating as much to traditional GICs as diversification guidelines will permit since GICs are unaffected by rising interest rates.

FCM investment decisions are based on the credit quality, risk, and relative value offered by all available stable value investment vehicles. To this end 24 years ago we developed and have continuously enhanced our insurance company credit assessment process and have stayed in close touch with insurance company contacts to keep fully current on the details and merits of new products as they become available. In addition, we have honed our skills and gained access to significant resources to assist us in evaluating non-proprietary evergreen strategies. Events over the past 3-4 years have provided challenges and have necessitated a continuation in the evolution of stable value. This evolution ironically now includes a return by our competitors, who are attempting to recreate their institutional memory, to the use of insurance company products that are very similar to those commonly employed at the beginning of what has now come to known as stable value. We at FCM have used these valuable tools continuously throughout our history and remain convinced not only of the appropriateness of stable value over other relatively low volatility investment alternatives but also of the significant value offered by insurance company stable value products in particular.

Don't give away your bell bottoms pants yet. They, as with insurance company stable value products, may come back in style.