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Yield Curve and Duration Management Considerations

With volatile equity markets during most of 2000 and October results looking dismal, the stable value market has begun to experience renewed interest. Stable value funds continue to represent roughly 20%-25% of assets in most defined contribution plans, even in a plan that offers as many as 10 to 12 different investment alternatives. This is a sizable commitment by participants, especially during a phenomenal run in the stock market since the early-to-mid '90s.

The recent renewed interest in stable value funds has come at an opportune time. With traditional GIC rates topping the 8.00% level during late spring and early summer, which had not been seen since the first quarter of 1995, traditional GICs have become very attractive relative to other securities available to stable value funds.

However, the change in the shape of the yield curve has thrown an added wrinkle into the question of "at what duration should contracts be purchased?" In 2000, the shape of the GIC yield curve has changed from positively sloped to nearly flat while the treasury yield curve moved from positive to inverted.

Although this resulted in larger GIC spreads over comparable treasuries on the longer end, the relatively flat GIC yield curve prompted many stable value managers to buy shorter duration GIC contracts, apparently in the anticipation that rates would continue to rise in the future, resulting in a more typical positively sloped yield curve. In contrast, FCM purchased GIC contracts on the longer end of the yield curve to capture the relatively higher rates for longer periods.

During a period in which there is a flat or inverted yield curve, as well as during a time with a normally sloped yield curve, there are a number of issues which need to be addressed before a particular stable value product is selected for a plan's portfolio. One of the first decisions is to select a portfolio management strategy which can range from: a passive style such as a buy and hold strategy, a semi-active style such as indexing, immunization, laddering, or barbell, or a more active style including interest rate anticipation or sector and security analysis.

While FCM employs certain of the elements from each style in managing stable value portfolios, we advocate the laddering strategy for GIC purchases in the buy & hold core of the portfolio. Simply stated, laddering is a strategy of holding securities with equally spaced maturities designed to spread reinvestment risk out over an interest rate cycle. There is a continuous stream of cash flow from maturities under this approach, which can then be reinvested at then current rates, thereby optimizing the portfolio tracking efficiency. The maturity ladder also provides for regular internal liquidity to provide for benefit payment and transfers to other investment options, which translates into higher rates offered by issuers since they do not expect to process unscheduled withdrawals over the term of the contract.

Once a portfolio management strategy is established, the yield to duration tradeoff of an individual contract purchase and the overall duration of the portfolio need to be examined at each investment. A normally sloped GIC yield curve calls for an analysis of the additional yield offered by incremental duration to determine the optimal point on the yield curve. Under a relatively flat GIC yield curve, such as we have been experiencing recently, or an inverted GIC yield curve, the current level of rates compared to the historical level of rates is also a vital consideration. Simply buying contracts with a shorter duration because there is little or no additional yield advantage may produce two results: 1) stacking up a large percentage of a portfolio's assets in the short term (0 -2 years) which will need to be reinvested within the same time frame in the future thereby making an implicit bet that interest rates will be the same or higher at that point in time than they are at the time of making the investment decision, and 2) experiencing a lost opportunity to lock in relatively high rates for longer periods of time. At FCM we employ a proprietary duration model that takes into account a historical look back in determining the appropriate duration target for the overall portfolio, rather than attempting to guess where rates may be in the future.

Participants choose to invest in their plan's stable value fund option because it offers preservation of capital, liquidity, high quality, and reasonable tracking of interest rates. Adding risk to the portfolio by introducing market timing may not be in the best interest of plan participants. A conservative, disciplined, and well-executed investment program has usually shown the best results over the long run.