Some $2 billion to $4 billion of derivative-based structured GICs have been placed with GIC managers and a few large pension funds during the past 12 months.
The structured GICs are introducing complex derivatives to the stodgy guaranteed investment industry as a way to diversify portfolios and enhance yields. But industry sources warn derivative-based contracts are not for everyone.
Structured GICs put a new spin on traditional GICs through the use of derivatives. They represent a significant departure from the traditionally conservative buy-and-hold insurance company GIC and the newer synthetic contracts.
Some industry sources and providers claim structured GICs are safe, offering higher yields than traditional GICs and providing additional opportunities to diversify a GIC portfolio.
Others claim the complex derivative-based contracts introduce added risk to traditionally conservative portfolios and are too complicated for the typical 401(k) stable value option.
Critics say the structured contract is a pure interest rate bet, a charge supporters do not deny.
Structured GICs resemble a callable bond with benefit responsive features. They more closely resemble a traditional general account GIC than a synthetic GIC in which the underlying assets are segregated from the general account or are owned by the plan.
In a structured GIC, investors are offered a premium of 40 to 60 basis points over traditional GICs or Treasuries with the same maturities by accepting the uncertainty of receiving return of principal prior to maturity. An initial lump sum deposit is made; interest accrues at an agreed upon fixed rate. The contract has a fixed maturity similar to traditional GICs.
After the lockout period, during which the issuer cannot call the contract (usually the first one or two years), the market interest rate, usually based on Treasury instruments or the London interbank offered rate, is compared with the strike rate. If the strike rate exceeds the market interest rate, the contract is called and the principal is returned. If the strike rate is below the market interest rate, the contract continues to maturity. The issuer then executes an interest rate swap with an outside counterparty exchanging a variable-rate instrument for a fixed rate guarantee for the contract.
Structured GICs are being issued by several life insurance companies and financial institutions such as Life Insurance Co. of Georgia, Security Life of Denver Insurance Co., Pacific Mutual Life Insurance Co., Sun Life of America, J.P. Morgan & Co., Rabobank Nederland and Lehman Government Securities Inc.
Chambers, Dunhill, Rubin & Co, the Beverly Hills, Calif., investment banking and investment contract specialists, has been instrumental in developing structured GICs.
Scott Sokol, managing director, called structured GICs the "quiet market" offering additional diversification and potentially higher yields.
Neither Mr. Sokol nor other industry sources expect structured GICs to match the explosive growth of synthetic GICs. But, "the market will continue to develop in a controlled way," Mr. Sokol said.
Issuers claim structured contracts do not subject portfolios to undue risk when portfolio managers conduct proper due diligence .
Joe Celentano, assistant vice president-pension investments at Pacific Mutual, said structured GICs "are no more risky to the plan sponsor than a traditional GIC. To them, it is almost identical, but it carries a variable maturity and a higher rate. ... The total risk is borne by the insurance company."
He said Pacific Mutual has just ended a six-week test market and has placed $20 million in the contract.
Harold Beal, marketing director at ING Institutional Markets, Atlanta, which distributes structured deals by Life of Georgia and Security Life of Denver, said structured contracts should be subjected to proper due diligence and credit analysis. He said the contracts are safe, and plan sponsors should not be overly concerned about them simply because of the use of financial derivatives.
Countered Ned Schmidt, president of Schmidt Management Co., a Deland, Fla., insurance market research firm: "Any (contracts) that may involve derivatives should send a cold shiver down our spines."
Peter Bowles, president and chief investment officer of Fiduciary Capital Management Inc., Woodbury, Conn., said he does not include structured contracts in his portfolios.
"We haven't been buyers. We are a conservative GIC manager and we believe that's what plan participants want. We don't invest in things we don't fully understand and how they work and how they fit into the portfolio. The more we think about it the more we are concerned that people don't fully understand what they are buying at times. Investment risks are ultimately passed through to the plan and to the plan participant," said Mr. Bowles.
One plan sponsor, who wished to remain anonymous, said structured GICs probably will not meet his investment criteria.
"We don't really see any advantage to structured products. A structured product is like a meeting. The more pieces you put together the more complicated it gets. If you have a meeting with a few people you can usually get things done. But if you have 30 people in the meeting you have problems ...
"The sellers claim these are for sophisticated investors, and no one wants to be seen as unsophisticated. In a stable value fund you must stand up for the participant. You can still get good performance without taking unnecessary chances," he said.
Bank pooled GIC funds have been among the busiest structured GIC purchasers.
Kelli Hueler, president of Hueler Analytics, a Minneapolis consulting firm that tracks more than 80% of the nation's bank pooled funds, said 15% of the Hueler universe currently hold structured contracts.
Ms. Hueler said structured contracts are not "speculative," but also are not common. He said such contracts usually are purchased by bank pools to enhance yield as well as to diversify the portfolio.
"There have been instances where we have questioned their use," said Ms. Hueler. "Generally I look at them as one of the positive things coming to the market. ... I think they will continue to grow in popularity but it does require some sophistication."
Karl Tourville, vice president at Norwest Investment Management, Minneapolis, which manages Norwest Bank's $1.4 billion bank pooled fund, said structured contracts represent about 5% of the portfolio.
Structured GICs "are no different than callable corporate bonds. We are now taking the technology used in the bond market for a long time and applying it to GICs. Structured contracts are as safe as a GIC to the extent they are issued by a triple-A rated bank or insurance company. The key is that you have added more uncertainty as to cash flow and you want to be paid for that call feature," said Mr. Tourville.
Bruce Goode, vice president at Society Asset Management Inc., Cleveland, which manages Society National Bank's more than $2 billion pooled GIC funds, said structured contracts represent less than 10% of the total assets. He said structured contracts represent high credit quality and do not carry excessive risk.
"We are not overly concerned about the safety. One of our primary concerns is with the bank or insurance company that does the business. You are more concerned with the credit quality of the issuer. We don't do business with lower credit quality institutions," he said.
Rich Cowan, principal at Brentwood Asset Advisors, Santa Monica, Calif., said he has not placed any structured contracts, but has examined some current offerings.
"There is some risk involved," he said. "They are not in widespread use, but they are definitely on the cutting edge of GIC investments. There is counterparty risk as well as interest rate risk involved with these contracts. They are probably not appropriate for the average plan sponsor, but the sophisticated investor who has the time and resources to conduct proper due diligence and some of the larger plans will be looking at them. For us it is difficult to quantify the risk associated with the extra yield you receive from them."