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The following article is reprinted with permission from the Stable Value Investment Asssociation Second Quarter Stable Times newsletter.

STABLE VALUE MANAGERS TAP GROWING ARRAY OF TOOLS TO HEDGE AGAINST INFLATION - by Randy Myers

Just as it is for any fixed-income security, inflation is a risk for stable value funds. Over the long term, it erodes the purchasing power of underlying investments, whether those are traditional guaranteed investment contracts (GICs) or bond portfolios backed by insurance wrappers. In the near-term, inflation fears can cause interest rates to rise and reduce the market value of those investments.

Lately, inflation has been on the upswing. The Consumer Price Index rose 2.7 percent in 2004, up from 2.3 percent in 2003 and 1.6 percent in 2002. It continued to climb through the first four months of this year, hitting an annualized rate of 3.5 percent by April, before backtracking to an annualized rate of 2.8 percent in May.

Fortunately, stable value managers are able to tap a broad and growing array of tools and strategies to mitigate the impact of rising inflation on their portfolios, including inflation linked bonds and inflation derivatives. To guard against increased interest rates brought about by inflationary fears, managers also can reduce portfolio durations by purchasing shorter maturity or floating-rate securities.

The market for inflation linked securities in the U.S. began in 1997, when the U.S. government began issuing Treasury Inflation-Protected Securities, or TIPS, which receive principal adjustments linked to movements in the U.S. Consumer Price Index, a popular measure of inflation. This market has expanded rapidly and now include securities worth more than $225 billion. As the TIPS market has expanded, other corporate, agency and municipal issuers have piggybacked on the investor demand for inflation-linked fixed income securities. Most recently, Aegon Institutional Markets late last year began selling "Inflation GICs," or "I-GICs," whose returns also are linked to the Consumer Price Index.

Which inflation hedges a stable value manager uses depends in part on the way his portfolio is invested. Alliance Capital, for example, exclusively manages wrapped bond portfolios, and it periodically invests in TIPS. "We use them opportunistically," says Greg Wilensky, Director of Stable Value Investments for Alliance Capital, "meaning we use them when the breakeven inflation rate--the difference in yield between a TIPS and a comparable maturity conventional Treasury-is below our longer term inflation forecast. We also have discussed using TIPS on a strategic basis-that is, adding them to the account benchmark-with some stable value clients and prospects."

Stable value manager Fiduciary Capital Management, by contrast, invests about 80 percent of its stable value portfolios in GICs and doesn't include TIPS in its portfolio. However, David Molin, Vice President and Director of Research for FCM, says the firm did buy a five-year Inflation GIC in January after comparing it to alternative investments, including TIPS, inflation-linked AA-rated corporate bonds and traditional fixed-rate GICs. At the time, the I-GIC's initial crediting rate of 4.53 percent was about 10 basis points higher than the yield on a five-year TIPS and 36 basis points higher than the yield on a comparable fixed-rate GIC, he says. By early June, the crediting rate was still about 10 basis points over a fixed-rate GIC. He says FCM calculates that the I-GIC will prove to be a better investment than a fixed-rate GIC if, over its five-year life, the CPI rises by an average of 3.10 percent or more annually. "With oil prices going up, we felt this would be a good hedge against any inflation scenario, including a potential oil crisis," Molin says.

I-GICs are built on a traditional floating-rate GIC platform. Their monthly interest payments are linked to year-over-year changes in the Consumer Price Index plus a fixed spread established at the contract's inception. For example, if the inflation rate based on the year-over-year percent change in the CPI was 3.5 percent at the time a contract was sold, and the spread was 100 basis points, the initial crediting rate would be 4.5 percent. Because of the seasonal factors and the spikes and troughs common in the CPI, the initial crediting rate on an I-GIC as with other floating-rate securities, may not be the best indication of the expected yield over the life of the security.

Pluses and Minuses While all of the inflation-protection tools available to stable value managers can help them manage inflation risk, each does so with a different mix of benefits and drawbacks. Floating-rate GICs, for example, do not provide the same direct hedge against inflation that I-GICs, TIPS or other inflation-linked securities provide, since their crediting rate is pegged to an interest rate, such as LIBOR, rather than inflation-and sometimes, interest rates are impacted by market factors other than inflation.

TIPS do offer a direct hedge against inflation, but differ from I-GICS and most other recently issued inflation-linked bonds in a variety of ways, including their underlying mechanics. As noted earlier, with TIPS, it is the principal of the bond that gets adjusted for inflation, while the coupon stays the same. With I-GICs, it is the crediting rate that gets adjusted. TIPS pay interest semi-annually, while I-GICs pay interest monthly. There is an active secondary market for TIPS, while no such market exists for I-GICs. Both inflation-linked securities issued by corporations and agencies and I-GICs provide opportunities for higher yields, albeit with higher credit risk, than do Treasury-issued TIPS, which are AAA-rated government-backed securities.

Aruna Hobbs, Head of the Pensions and Savings Group at Aegon, argues that one of the primary benefits of hedging inflation risk with I-GICs is the opportunity to diversify an investment portfolio while also capturing what has been a fairly high initial crediting rate-about 4.7 percent in late May. Back then, that was roughly in line with the crediting rate available on traditional GICs of the same maturity. I-GICs, like other inflation-linked securities, also offer portfolio diversification benefits to stable value managers. Thanks to their built-in inflation hedge, they offer low or even negative return correlations with bonds and many other asset classes.

Hobbs says the spread available to I-GIC investors at any given time will vary depending upon market conditions. Generally, the spread will be smaller when inflation expectations are high, and larger when inflation expectations are low. Early this year, the spread was hovering around 100 to 120 basis points.

Hobbs says she expects buyers of I-GICs to be plan sponsors and their intermediaries, including pooled funds, that traditionally purchase guaranteed investment contracts and are looking for inflation hedges or yield enhancements. They also may appeal to stable value funds that invest in medium-term notes. By May 2005, the firm had already sold five contracts and was nearing completion of a sixth deal. Although Aegon was the only institution selling I-GICs early this year, Hobbs recognizes that additional players may enter the market. In fact, she says, "We are hopeful that there is going to be a lot of demand and that this will encourage people to institutionalize the product. When it starts to become more mainstream, there will be a natural need for more providers."

With the growing array of hedging tools available to them, stable value managers may not be able to ignore inflation risk, but they can manage it.