403(b) Curriculum Library

Plunging Interest Rates’ Impact on Stable Value Funds

What’s Happened to Interest Rates in Recent Weeks?

The spread of the coronavirus and the plunge in oil prices have led to an unprecedented decline in bond yields across the globe. With the unforeseen events of recent weeks, the 10-year Treasury yield hit an all-time low of 0.31%, closing the day at 0.55% on March 9, 2020. Keep in mind, the 10-year Treasury yield was trading above 1.5% in mid-February.

How are the Rate Moves Impacting the Fixed Income Funds Typically Held in Retirement Plans?

Since fixed income investments move inversely with interest rates, the collapse in bond yields has led to significant price appreciation across most fixed income sectors in recent weeks. This is exactly the role bonds are expected to play in a diversified portfolio mix, providing stability and income when risk assets come under pressure. The one exception is the high yield bond sector, which tends to be more correlated with equities and the economic environment.

What Impact are Collapsing Bond Yields Having on Stable Value Funds?

In general, periods of risk-aversion tend to be positive for stable value funds, both in terms of cash inflows (as investors pull back on risk) and price appreciation from declining interest rates. However, there are nuances within the types of stable value products that may cause divergences from manager to manager.

Synthetic GIC Stable Value Products

Since stable value contracts are designed to smooth the impact of both rising and falling interest rates, the recent move in interest rates should not have an immediate impact on the crediting rate. Declining interest rates increase the market value of the underlying holdings, which leads to an increase in the market-to-book values. Market-to-book values across the stable value universe are largely in good shape (due to lower interest rates in 2019), so portfolios are well-positioned to absorb any losses on the credit side of the portfolio, due to recent spread widening.

Since the Great Financial Crisis, stable value funds have stricter guidelines and the underlying credit exposure is largely limited to investment-grade credit and securitized debt. For now, these sectors are holding up relatively well in the current market environment.

General/Separate Account Stable Value Products

The vast majority of general/separate account products have fixed guarantees ranging from 1.0% to 3.0%. With the entire U.S. yield curve now trading through 1.0%, there will undoubtedly be pressure on the insurers to boost their capital requirements, in order to meet these guarantees.

This is where the financial strength of the underlying insurer and the organization’s capacity to deal with further margin/profitability compression starts to kick in. As of now, we are not aware of any negative reviews from rating agencies, however, the moves we have had are large and significant. Therefore, pressure is mounting, especially if rates are sustained at these levels for an extended period of time.

What Happens to Stable Value if the U.S. Goes Into a Negative Interest Rate Environment?

Given the smoothing nature of crediting rates, stable value managers would have time to determine what to do if the U.S. interest rates go negative. The amortization period depends on the duration of the stable value product (i.e., the longer the duration, the more time it takes to smooth the gains/losses).

While rates are currently at historic lows, yields on spread products have widened significantly in recent weeks. This creates an opportunity for stable value managers to add risk to the portfolio and minimize the impact of the low interest rate environment.

Under a worst case scenario, it is conceivable that a stable value provider could cease to offer the product to new clients or have a “soft close” on new contributions, if the business risk is too great or the market environment is no longer conducive for offering the product. Given the added fees in these type of products, stable value managers are not likely to “subsidize” expenses like money market managers have done over the last decade as rates remained near zero.

Editor’s Note: This piece was written on March 10, 2020.

Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice. Opinions expressed are those of the author, and do not necessarily represent the opinions of Cammack Retirement Group.

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