Sunday, October 26, 2008

Stable Value Fund Due Diligence

Stable value funds often invest in a portfolio of fixed income investments beyond the average term and allowable credit quality of a money market fund. The term premium and credit spread is intended to provide a return over money market products while insurance contracts provide book value accounting and loss protection for participant withdrawals prior to maturity.

Stable value funds seeks to provide a stable net asset value and crediting rate by managing portfolio cash flows, managing the duration, quality and diversification of the underlying fixed income investments, amortizing market value based portfolio gains and losses over the duration of the portfolio and by utilizing wrap providers who are contractually required to make up the difference between portfolio market value and book value under certain circumstances.

This has been a challenging environment for stable value products as the recent spike in credit spreads has driven market values below book value in many stable value funds. High quality stable value products are now seeing market values at 95% and less of book value. Issuer specific credit events may also be causing problems for funds with concentrated exposures. Structured credit products continue to present liquidity, pricing and credit risk for underlying portfolios. Lastly, financial issues in the insurance and banking sectors have impacted the credit quality and capacity for wrap providers. Given these issues it would be prudent for investors with fiduciary responsibility to review the condition and operation of their stable value funds and to identify any general or specific risks and issues.

Credit and duration position. - Longer duration and lower credit quality in the underlying portfolio presents more risk. Funds with MV/BV ratios under 1 may be shortening duration to amortize their negative book value differences more quickly. Underlying portfolios should be well diversified by sector and issuers and shouldn’t have material positions in investments subject to inappropriate liquidity or default risk. Any structured investments should be very short duration and fully covering P&I. Inquire about the market valuation methodology for any structured investments in the underlying portfolio.

Cash flows - Substantial issues can arise in a stable value fund if cash-flows are negative when the portfolio market value position is less than the book value position. At that point, participants are effectively getting a $1 worth of assets when they leave and the fund is getting less than $1 in asset sales proceeds to pay them out. This inequity drives stable value managers to try to avoid book to market differences beyond a 5%-6% spread. Book to market value differences can be managed by reducing portfolio duration, thereby speeding up amortization and increasing portfolio quality while reducing spread risk The more severe the market value discount, the more the underlying portfolio characteristics should resemble a money market fund. In these cases, principal protection should take precedence over the yield and crediting rates. Stable value contract restrictions are designed to impede negative cash-flows. Stable value products often have a put option on sponsor level withdrawals in situations where there is a negative impact to existing fund holders such as when MV is less than BV. Plan participants don’t usually have withdrawal restriction per se but competing fund rules and required “equity washes: can serve to minimize participant withdrawal activity.

Wrap – SV funds faces deteriorating credit quality and diminishing capacity in the wrap market. As a practical matter, SV funds might have to get to a crediting rate of zero or experience substantial net cash-outs before the wrap providers would suffer a claim. While the probability of this occurring simultaneous with a wrap provider’s insolvency may have been historically small, fiduciaries are faced with unprecedented market conditions. SV managers should be very aware of the issues they face in this environment and should be proactively managing them .

Monitoring a stable value funds MV/BV ratio, underlying portfolio attributes, cash-flows and wrap exposures are important due diligence steps for a plan fiduciary in this environment.

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