The recent market environment, which has been defined by rising interest rates and an inverted yield curve, has presented unique challenges for stable value funds. One we believe requires close attention is withdrawal risk — the probability a manager will need to sell securities from their long-term strategies (generally, mark-to-market synthetic GICs) to fund participant and/or plan withdrawal requests.
Withdrawal risk is more acute and detrimental during periods of rising interest rates and/or widening credit spreads. When bonds are sold below book value from wrapped strategies, any realized loss is embedded in the market-to-book ratio of that strategy.
This is important because the market-to-book ratio is one of the key determinants of the crediting rate for synthetic GICs and portfolio yield. This is especially relevant in the current market environment, as market-to-book ratios are at their lowest point since the global financial crisis of 2008. Visit “Why withdrawal risk matters in stable value funds” for an in-depth discussion.
Value of liquidity: Mitigating withdrawal risk and protecting market-to-book ratios
At Putnam, we structure our Stable Value Fund to have at least 1.5% to 3% of fund assets mature at par every quarter. Additionally, in our withdrawal hierarchy, our two underlying wrapped strategies, which have fluctuating market values, are placed behind our cash and traditional GIC allocation. When combined, this represents over 30% of the fund as of March 31, 2023. This buffer, which maintains its book value regardless of movements in interest rates, significantly protects our wrapped securities from withdrawals.
Historically, the buffer has shielded us from having to sell bonds from our synthetic strategies for withdrawal purposes. Not only has this alleviated the embedded-loss issue, but it also has allowed our portfolio managers to focus their trading on total return enhancement via security selection and sector rotation. We believe our liquidity-focused structure provides incremental stability to the fund’s market-to-book ratio and crediting rate over time. We discuss different capital preservation fund structures in “Rising rates, inflation, and the future of “cash” in 401(k) plans.”
Industry update: Stable value vs. money market
With the yield curve inverted, government money market funds yield more than stable value fund crediting rates. While we acknowledge the reality of the current market environment, we believe this yield advantage of government money market funds is a short-term phenomenon and must be discounted as such.
Investors should focus on evaluating longer-term returns for both products given retirement investing is a long-term endeavor. In this context, stable value funds continue to provide a significant annual return premium over money market funds.
Stable value funds are shown to have an average annual return premium above 3-month U.S. Treasury bills of approximately 166 basis points. Importantly, this return advantage includes multiple time periods when the yield curve was inverted, as it is today, including the late 1980s, early 2000s, and the period leading up to the global financial crisis.
The following chart compares the 3-year rolling returns for stable value funds and the ICE BofA U.S. 3-Month Treasury Bill Index (a proxy for government money market returns) over the past 30+ years.
Putnam Stable Value Fund outlook
Our stable value strategy has remained consistent in recent months. On the investment front, we continue to structure our synthetic strategies in a defensive manner given the market uncertainty we expect moving forward. For example, we are currently keeping duration neutral, focusing on higher-quality securities, and limiting spread duration on new purchases to 3 years or less. We have been assessing opportunities to add exposure in sectors that have recently underperformed, particularly within corporate credit and mortgage credit.
Additionally, we have consistently allocated assets to the short end of the curve to capture yield advantage, while not ignoring reinvestment risk in longer-term securities. We believe this balanced approach is prudent given our broader macro view. Overall, we prefer to have an abundance of liquidity to handle any potential participant outflows, while also being able to capture opportunities in the post-Federal Reserve pivot environment.
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