What to do When Interest Rates Rise

The attraction of stable value to participants, especially older and more risk averse participants, is that it offers both "preservation of capital," as does a money market fund, and also an attractive return significantly in excess of inflation, unlike money markets. Moreover, unlike company stock, the wide variety of equity options and bond funds, participants investing in stable value are insulated from market volatility and the anxiety of sudden changes in his/her retirement assets. As illustrated by the performance charts included on page 5 of this UPDATE, with returns comparable to bond funds but without the interim volatility, a well-managed stable value portfolio will produce consistent and predictable returns. However, if the portfolio is not properly managed during a rising interest rate environment, the yield on a stable value fund can significantly lag some of the indicators to which participants will compare it, such as CDs and money market rates, leading to discontent and loss of confidence in the stable value option.

Many participants view stable value funds, money market funds, CDs, and bond funds at the same end of the risk spectrum. Clearly the performance of money market funds, with annualized returns currently in the 1.00% to 1.50% range, has been much less attractive than stable value. But until June 2003 when interest rates hit a 40-45 year low, bond portfolios had been producing the most attractive returns of any of the 401(k) options available. However, in the long run a bond portfolio (or the actively managed bond portfolio underlying an evergreen synthetic in a stable value fund) will produce total returns equal to the income return on the portfolio plus (or minus) the value-added by the manager. In the long run, 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! And so when investing in bonds directly as a plan participant may or indirectly as in the evergreen synthetic portion of a stable value fund, it is important for an investor to be mindful of where we happen to be in the interest rate cycle. Although the general level of interest rates have risen about 140 to 160 basis points since June 2003, they are still at very low levels in their historic range and stable value managers need to remember that the lower interest rates are the greater the probability that the next significant change will be an increase in rates, possibly resulting in significant capital losses in bond portfolios.

The crediting rate formula in the wrap contract associated with an evergreen synthetic allocation in a stable value portfolio effectively amortizes forward the capital losses that result when interest rates rise. As a result, even though the yield on the underlying bond portfolio will rise when rates go up, the crediting rate will lag current rates because it is impacted significantly by the capital losses. So how does a stable value manager achieve the results that have become so popular with participants and minimize the "lag effect" when rates are rising?

By taking advantage of the spectrum of alternatives available, FCM opportunistically selects investments that will produce attractive relative values. FCM uses liquidity and duration management to improve a portfolio's tracking efficiency and to manage cash flow distortions. It only makes sense to shorten portfolios when rates are low and the converse, so we developed a proprietary duration management process to impose a discipline on ourselves by looking at historic relationships rather than speculating on when rates may rise in the future and by how much. FCM purchases buy & hold fixed maturity products, including GICs and wrapped bonds to provide internal portfolio liquidity through well-laddered maturities. Due to their historic 0.38% yield premium, low default rate and very high recovery rate; FCM has employed a higher allocation to traditional GICs than wrapped bonds in light of their relative value, while being mindful that the GIC segment must be well diversified. The insurance industry is one of the very highest rated by the agencies, with an average financial strength rating of AA-, defined as "very strong." Moreover, GIC issuers are industry leaders with strong market positions in their core business lines and even higher quality than the insurance industry at large. We fully expect that the insurance industry, and particularly the GIC issuing segment of the industry, will continue to demonstrate its historic strength relative to other industries over time. Most important at this point in the interest rate cycle is that GICs and the crediting rate on buy and hold wrapped bonds are not devalued when interest rates rise. So in a rising interest rate environment, we will be allocating new net positive cash flow to the funds we manage to GICs and opportunistically to bonds that exhibit a minimum of extension risk.

Wrapped fixed income "evergreen" portfolios in a stable value fund offer industry and securities diversification, improved liquidity of the underlying securities and the possibility of increased credit quality. But they also pass through any gains or losses experienced via the crediting rate formula, so we avoid allocating new money to them when rates are relatively low, as is now the case and the converse when rates are high by historic measures. Moreover, it is critical to employ fixed income managers who have a demonstrated ability to outperform the unmanaged benchmark indices. Consequently, FCM serves as a manager of managers for the evergreen sector in our portfolios, by drawing upon our investment-consulting heritage, carefully selecting out-performing fixed income sub-advisors, monitoring them closely, and exercising our independence from the sub-advisor by replacing them when necessary. FCM's goal is to select sub-advisors with distinctly different fixed income management styles which in turn have different market cycles, so that the fund can achieve less volatility for the evergreen wrapped bond component in total than would otherwise be the case with just one sub-advisor.

To keep participants happy over time it is necessary not only to produce an attractive return but also to minimize the "lag effect" when interest rates are rising. Using GICs in a laddered maturity structure takes advantage of their yield premium and gives the manager the opportunity to shrink duration directly when rates are low so that more money will be available to reinvest when rates begin to rise. And allocating less new cash flow to "evergreens" will minimize the amount of capital losses that are passed through via the crediting rate formula.