Stable Value Versus Rising Rates
If you own a short-to-intermediate term bond portfolio, and you did not need to tap the cash for a few years, would you prefer rising short interest rates, or falling rates? The correct answer is rising rates, because you will be able to reinvest interest payments paid in higher yielding securities. That’s why I take [...]

If you own a short-to-intermediate term bond portfolio, and you did not need to tap the cash for a few years, would you prefer rising short interest rates, or falling rates?  The correct answer is rising rates, because you will be able to reinvest interest payments paid in higher yielding securities.

That’s why I take issue with the following article on stable value funds from the Wall Street Journal.  Some might remember my “Unstable Value Funds” series.  Though the worst never happened, many funds came close to “breaking the buck.”

I once designed a substitute for Stable Value Funds, one that could trade on Schwab’s platform.  But the math of the product meant that it could be blown apart by a very rapid rise in short rates.  To try to remedy that, I rewrote the pension services contract to put in  a Force Majeure clause that would allow  the insurance company to alter many terms of the contract to avoid “breaking the buck.”   (In 1997-8, I thought ahead, and designed a contract that had modes for normal and abnormal environments. Hey, Nationwide Insurance, it’s your intellectual property now. Use it.)

My main point is that stable value funds will lag in a rising rate environment.  Yes, it will not appear that you are losing money in the short run. but the credited rate will lag for 2-3 years, while returns to the short-to-intermediate term bond portfolio will be hurt in the short-run, but do well in the intermediate-term.

Be wary.  Even though Stable Value funds do not face credit risk problems now, rising rates would invite anti-selection by making short-to-intermediate term bond funds look attractive, even with the 90-day switch into equities or longer bonds.

Remember, Stable Value funds are bond funds that pay a little extra to guarantors, so that payments for death, disability, fund switching, etc., go out at book value.  They have to pay the fund management fees and the small guarantor fees.  The short-to-intermediate term bond fund can invest a little more aggressively, and only has to pay out the management fees.  Over the long haul, the short-to-intermediate term bond fund will beat most Stable Value funds, but the ride will seem more bumpy, because except in the worst scenarios, the Stable Value fund acts like a savings account, slowly accruing value, while the underlying investments actually behave like a short-to-intermediate term bond portfolio, with all of the volatility.

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