The Death of Stable Value Funds

Tom Beilstein, CFA, Portfolio Manager

When the Federal Funds rate reached 1.75% in December 2002, we began to worry about protecting the principal of clients’ money invested in fixed income. The fear was that when rates inevitably rose, principal on most bond funds would decrease. We considered a number of options, but the one that was most appealing was stable value funds.

How do they work?

Stable value funds are mutual funds that are designed to maintain a stable NAV, usually $10.00. The funds hold a portfolio of bonds, similar to your basic short- or intermediate-term bond fund. However, stable value funds come with insurance. The funds negotiate “wrapper” contracts with insurance companies to ensure the stable NAV. When the bonds in the portfolio appreciate, the insurance company receives the insurance premiums plus a share of the appreciation. When the bonds in the portfolio depreciate, the insurance companies pay the funds the dollar amount that brings the NAV back to the $10.00 level. These funds were ideal for a rising interest rate environment because they essentially had no interest rate risk. The major risk in owning these funds was the solvency of the insurance companies, which was very small since the insurance companies writing the “wrapper” contracts were highly rated companies.

What was the problem?

In a nutshell, the SEC did not like the accounting methods used by the funds. In early 2003, the SEC informed stable value fund providers of its intent to re-examine whether the prevailing “wrapper contract” valuation methodologies were consistent with the Investment Company Act of 1940 and GAAP, Generally Accepted Accounting Principles. The question seemed to revolve around how a “wrapper contract” could have a different value each day, always at the precise amount necessary to value the fund at $10.00. The SEC’s review applied strictly to registered funds as opposed to unregistered funds, which will remain widely available in 401(k) and other defined contribution plans. During the re-examination period, the SEC assessed the current valuation methodologies and various alternatives that would preserve the unique investment benefits provided by the stable value funds. Although the SEC has not yet rendered an opinion on the matter, the writing was on the wall, as each of the stable value funds closed their doors.

Conclusion

We were very disappointed in the mutual fund companies’ decision to eliminate stable value funds, although we understand it was clearly linked to the SEC’s inquiry. The decision eliminated an investment class just when it would prove to be most valuable. The decision mostly benefits the insurance companies. Up until now, interest rates kept dropping and the insurance companies continued to receive their insurance premiums without having to pay anything into the funds. With rates beginning to rise, the insurance companies were on the brink of having to pay for the first time. It is ironic that the SEC’s decision benefits the insurance companies in light of the fact Elliot Spitzer has turned his watchful eye in their direction.

In any event, we are disappointed to lose this asset class. We will allocate most of the money in stable value funds to investments that offer an acceptable level of price stability and total return, such as short-term bond funds and floating rate bond funds.