Managers of stable-value portfolios have wish lists that at first glance look impossible to meet: no losses, growth every month, and - because 401(k) plan participants typically compare the rates they're getting with what they're seeing in the bank windows - responsiveness to rising rates as well.
That last goal certainly loomed large last year, and still does today in an uneasy bond market. The problem is, how can you deliver a vehicle that grows steadily and remains rate-responsive at the same time? One of the great virtues of actively managed synthetics is their ability to come much closer to that ideal than traditional guaranteed investment contract portfolios. To see why, let's examine some fundamental risk/reward profiles.
Traditional GICs are risky
To the average plan participant, "GICs" and "risk" aren't words that go together. Backed by highly rated insurance companies, GICs typically are seen by participants as like Treasury bills in safety.
However, that's not the view the plan sponsor should take in making investment decisions.
For one thing, as we all know after some well-publicized failures, GICs aren't really "guaranteed." Like any bond, they're only as good as their issuers. For another, all of those issuers are from the same industry; they're either insurance companies or banks. So while a GIC portfolio may hold a number of different securities, it's not really diversified.
And just as it's the rare sponsor who would permit a manager to buy bonds only from a single industry, a stable-value portfolio confined to traditional GICs is simply too concentrated for most plans.
All of this means that while most GIC portfolios have a duration of about 2.5 years, half that of the fixed-income market, their risk is actually some three-quarters of the market level.
In other words, managers who rely on traditional GICs are likely to get less than market return (because the duration of typical GICs is shorter) while incurring a considerable amount of risk.
100 basis points better
As more plans have been discovering, you can do appreciably better than GICs with actively managed synthetics - "wrapped" bond portfolios. With the longer maturity of the bond market as a whole, plus the power of value-added management to add a premium on top of that, Bernstein research shows active synthetic portfolios should beat traditional GIC options by roughly 100 basis points a year on average.
While it's true some of that gap can be closed by purchasing longer-than-average GICs, plans would have to go to 10-year-maturity vehicles to match the duration of the typical synthetic, which most sponsors and GIC managers would be loath to do. Even with matched durations, an actively managed synthetic will have a higher expected return than a traditional buy-and-hold GIC.
Don't lag the bank window
So, to get back to our ideal investment - high return, stable value and responsiveness to rising rates - on the first score an active synthetic is clearly a superior way to meet participant demands. On the second, the wrapper guarantees that for employee-initiated withdrawals, participants will receive principal plus accrued interest (and, unlike a GIC, the plan owns the underlying investments with a synthetic).
But what about that third criterion? After all, the longer the duration, the longer it takes a given change in interest rates to get reflected in the yield of a fixed-income portfolio. So you'd think a synthetic would respond more slowly than GICs to rising interest rates. In fact, it works the other way around.
Display 1 shows five-year Treasury yields over the last decade compared against the crediting rates on both traditional GICs - a laddered portfolio of five-year contracts - and actively managed synthetics (using a representative Bernstein construction). The GIC rates tended to be higher than the bond yields and reacted to their general direction - but not all of the time, and with a dramatic lag.
The problem isn't hard to understand, because the only thing that changes a GIC rate is the substitution of a new contract for one that's maturing. If you have, say, a 20-contract portfolio, laddered quarter by quarter over five years, only one-twentieth of your value matures in any given quarter. Essentially, once a quarter you're substituting today's yield for the yield that prevailed five years before; if current interest rates are rising but still lower than they were then, the rates your participants see in their bank windows are on the way up, while the rate on their stable-value option continues to drop. This is exactly the kind of disparity you'd like to avoid, and can, with synthetics, whose crediting rates have not only been higher than GICs - the advantage of longer duration and active management - but have reacted more quickly to changes in the prevailing interest rates.
Looking toward current yields
By design, synthetics always move toward what's currently happening. While a traditional GIC portfolio is harking back to what happened five years ago, the rate on an actively managed constant-duration synthetic is set to take current market yields into account. And because the environment quite recently was one of rising rates, Display 2 examines a couple of such time periods.
The left panel of the chart isolates the last nine months of 1987: While bond yields headed sharply up during most of this bear market, traditional GIC rates were still coming down, as earlier, higher-yielding contracts were shed. In contrast, the rate on synthetics began moving up in stepwise fashion, and remained higher than what the banks were offering. This responsiveness is exactly what participants would have expected.
The right panel of the chart presents the even more dramatic picture of 1994, when dropping GIC rates actually went "underwater" - below bond yields (not for the first time, as is clear from Display 1). In other words, despite the extraordinary spike in rates over the course of 1994, by year end, old contracts falling out of traditional GIC portfolios were still being replaced with lower-paying ones.
Synthetics, on the other hand, held their own: to be sure, their spreads over prevailing bond yields narrowed some, but they continued to be positive.
Meeting all the goals
One of the items on our original wish list was stability, and in our view, it's the stability of account value that's critical.
Where crediting rate is concerned, participants want movement. They don't want to be out of the action - as long as rates are on the way up. In the opposite environment they aren't thrilled to see their rates go down, but they expect it when yields are declining in their bank accounts and their money funds - and in most cases seem satisfied as long as they're getting more from their stable-value funds. It's when rates are rising and stable-value options aren't keeping up that participants tend to be most troubled. One of the ways actively managed synthetics represent a step forward in the stable-value marketplace is by helping minimize those occurrences.
C. Jason Psome is managing director of stable-value fixed-income services at Sanford C. Bernstein & Co. Inc., New York.