Tighter investment guidelines imposed by wrap providers

After excessive risk-taking in the years leading up to the financial crisis, stable value managers have centered their investment strategies on more conservative practices.

The move is due to the unexpected under-performance of highly-rated structured securities and pressure from wrap providers, which decided against insuring portfolios that had become too risky. The prospect that interest rates, which have been at historically low levels, are bound to rise soon is also prompting safer investments in stable value funds.

Some of the trends in investment practices at stable value managers include focusing on shorter durations and higher quality paper. They are also imposing more restrictions on competing funds.

Higher credit, shorter duration

"There's a general trend toward less credit exposure and shorter duration, two major risks that wrap providers had," said James King, senior vice president and head of stable value markets at Prudential Retirement.

"Wrap providers are generally wrapping portfolios with more conservative investment guidelines," agreed Ron Heath, managing director of sales and marketing at Morley Financial Services Inc., which has $14 billion under management. "They're putting more duration constraints on portfolios."

Stable value funds had traditionally focused on bonds with high credit ratings and short duration, but investments in high-yield securities and long credit had become common at many stable value managers in the years leading to the financial crisis, mostly to increase yields and boost returns. Wrap providers are now forcing stable value fund managers to go back to basics, asking managers to be more conservative as providers refuse to bear the brunt of risk.

While investing in junk bonds wasn't common at all stable value managers, the strategy wasn't unheard of between 2006 and 2008. Now the credit quality of investments requested by wrap providers has to be much higher. Typical investments in stable value funds again include agency bonds, securitized credit with very high credit ratings and Treasuries.

"We can offer a large exposure to corporate credit relative to the industry," said Eric Hasenauer, managing director and head of sales at Aviva Investors North America Inc. "Often times, stable value funds are required to hold a large amount of securitized investments." He added that although no high-yield credit is allowed in Aviva's portfolio, there is flexibility with regard to asset allocation.

"I'm seeing less of an appetite for wrapping high yield and non-dollar denominated securities," Mr. Heath concurred. Karl Tourville, managing partner at Galliard Capital Management, said that more than 75% of the assets in his firm's stable value portfolios are invested in obligations of the U.S. government, in agencies or in securities rated AAA. He added that stable value managers have the primary goal of preserving principal while providing a competitive yield for plan participants. "Therefore, higher risk investments such as high-yield bonds or non–dollar denominated securities would go against the conservative principles of stable value investing." Galliard has more than $67 billion in assets under management for 220 institutional clients.

Meanwhile, the duration of stable value portfolios has been shrinking, generally to maturities around three years from as long as five years prior to the financial crisis, although it can vary from firm to firm. Targeted duration at Aviva, for example, is four years. The duration of a stable value collective fund advised by Galliard is currently nearly two and a half years, Mr. Tourville said.

"We have begun reducing our overall portfolio durations to position our portfolios for an eventual rise in interest rates," he said, adding that it would allow the manager to reinvest portfolio cash flows more quickly as rates move higher. "One way we are doing this is by increasing our portfolio allocations to cash equivalents." A Galliard-advised portfolio, which may have historically held cash equivalents of approximately 7% to 10% of a portfolio, may now hold 10% to 15%.

Stronger cash buffers

Galliard took advantage of large inflows during the last several years, prompted by investors looking for safer havens. "We want to be more liquid in the event there are more outflows, as well as to benefit from rising interest rates," Mr. Tourville said.

Galliard isn't the only manager to have followed that strategy. Cash reserves in many stable value funds have also grown and are larger than prior to the financial turmoil. "The cash buffer has been trending up a bit to allow some excess liquidity," said Mr. Hasenauer of Aviva.

"There's probably more cash than at the beginning of the financial turmoil, but less cash than at the peak of the crisis," Mr. King said.

Market-to-book ratios have recovered and increased as a result. They were hovering around 102 as of the end of 2010, after having peaked at 104 in the third quarter. "The state of the stable value industry has improved in the past year," Mr. Heath said. "Market-to-book-value ratios have been back over 100 for some time." He added that wrap providers have generally been requesting more diversification in portfolios.

Wrap providers are also expanding the definition of competing funds, which have the purpose of avoiding arbitrage investments between stable value funds and other funds in rapidly rising interest rate environments. "Wrap providers have always required an equity wash if a plan has a money market fund, short-term bond fund or other products that provide a guarantee of principal," Mr. Heath said. But now wrap providers are including other types of funds in the mix. "Wrap providers have also looked more closely at Treasury inflation- protected funds and at brokerage windows where you could have access to competing funds."

"What has changed is the definition of what is considered to be a competing fund option," Mr. Tourville said. "Now the definition has expanded to include investment options such as self-directed brokerage windows, lifestyle funds with a specific allocation to a competing option and TIPS funds. So we're now dealing with a much broader universe of what is considered a competing fund."

Experts agree that the trend toward more restrictions imposed on stable value managers, higher wrap fees and tighter investment guidelines may be generally good for the overall health of the stable value industry.