We believe that risk measurement in stable value funds is more complex than simply utilizing the methods applied to standard bond funds. Comparisons using traditional bond fund metrics such as duration, sector composition, and credit quality are important components in any due diligence process.
However, another important factor to consider is withdrawal risk — a unique risk factor in stable value strategies that plan committees, advisors, and consultants may overlook as they compare one strategy with another. Ignoring the withdrawal risk in a stable value vehicle can lead to an incomplete picture of the total risk profile of the strategy.
Cash flow can pose challenges
Withdrawal risk is defined as the probability that a manager will need to sell securities from their long-term strategies (generally, the synthetic GICs) to fund participant and/or plan redemptions.
Evaluating this risk in a stable value strategy is important because of the uncertain nature of cash flow into and out of the fund, both of which affect the crediting rate. Changes in the crediting rate alter future returns, particularly if outflows are met by accessing the wrap contracts on synthetic investments. Accessing these wraps involves selling underlying bonds from a synthetic GIC at the current market value.
For stable value managers, predicting cash flow is a challenging task, particularly in non-crisis periods. Consequently, planning adequately for periods of fund outflows also becomes challenging if not accounted for well in advance. For example, after significant inflows into our strategy at the beginning of the Covid-19 pandemic in March 2020, we have yet to see any significant reversal in flows back to alternative investments. Investors behaved quite differently during previous crises, such as “Y2K” and the global financial crisis in 2008. After the initial shock of those two events, a significant amount of participant-driven money migrated back to riskier assets as markets stabilized.
Withdrawal risk is more acute and potentially more detrimental during periods of rising interest rates and/or widening credit spreads. If bonds are sold from wrapped strategies to fund withdrawals at a discount/loss, that loss is embedded in the market-to-book ratio of that strategy, as the securities sold do not have any chance to recover the losses. This is important because the market-to-book ratio is one of the key determinants of the crediting rate for synthetic GICs (along with portfolio yield). This year will likely be a challenging one for these ratios, as the bond market is pricing in multiple interest-rate hikes from the Federal Reserve. Furthermore, higher levels of volatility may result in wider credit spreads and lower bond returns.
Evaluating fund structure is key
Due to the challenges in projecting cash flow, we believe it is prudent to build ongoing, permanent liquidity into a stable value fund’s structure. Specifically, creating a structure with scheduled maturities at par may prevent managers from having to sell assets from their wrapped strategies to accommodate potential outflows.
At Putnam, we structure our Stable Value Fund to generate at least 1.5% to 3% in assets maturing at par every quarter. Additionally, our two underlying wrapped strategies (which have fluctuating market values) are placed behind our cash and traditional GIC allocation (which represented approximately 30% of the fund as of December 31, 2021) within the fund’s withdrawal hierarchy. This 30% buffer, which maintains its value regardless of movements in interest rates, protects our wraps from withdrawals to a significant extent. Historically, the buffer has shielded us from ever 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 purely on total return enhancement in those strategies (security selection and sector rotation). Overall, we believe our liquidity-focused structure will provide incremental stability to the fund’s market-to-book ratio and crediting rate over time.
The effect of withdrawals: An illustration
To help demonstrate the impact of withdrawals, consider the following hypothetical comparison. Two stable value portfolios begin with the same yield (2%), duration (3 years), and market-to-book ratio (100%). Then the below market/cash flow scenario occurs:
- Interest rates rise by 25 basis points for five consecutive quarters. During this time, each fund’s yield rises by the same amount (0.25% per quarter) while the duration of each fund stays constant.
- Both funds have redemptions that represent 2% of total assets under management each quarter.
- Portfolio A handles the withdrawals through its liquidity structure (without selling bonds from its wrapped strategies), while Portfolio B is forced to sell bonds from its wrapped strategies to fund the withdrawals.
At the end of the five quarters, the crediting rate on Portfolio A is 0.25% higher than Portfolio B (see chart below). This is because the sale of assets from the wrapped strategies in Portfolio B caused the market-to-book ratio of Portfolio B to deteriorate by even more than the effect that rising interest rates had on underlying bond prices.
Accessing wrap contracts for withdrawals in a rising rate environment can negatively impact crediting rates
Source: Putnam Investments.
Given this hypothetical outcome, we believe that protecting wrapped strategies from the need to sell bonds to fund withdrawals in a rising-rate environment can make a difference in future returns.
As mentioned, the interest-rate backdrop in 2022 is changing as the Fed moves to quell inflation. As such, market-to-book ratios for all managers are likely to fall below 100%. In this environment, it is crucial to know a stable value fund’s liquidity structure and whether that structure increases or decreases the likelihood that a manager will have to sell assets at a loss to fund withdrawals. This unique attribute in stable value funds is one that should be thoroughly considered and understood when comparing differing strategies and structures.
Looking at the details in stable value funds
In summary, managers should consider the differences among stable value funds using traditional bond risk metrics like duration and average quality as well as the history and likelihood of future withdrawals. What’s more, we believe the probability of withdrawals from wrapped assets is the most important risk to track, as embedded losses from this type of cash flow can overwhelm the future return profile of a fund compared with the other traditional bond fund risk factors. Consider consulting with your stable value fund manager about their approach to this important structural characteristic.
At Putnam, we structure our Stable Value Fund to provide incremental stability to the fund’s market-to-book ratio and crediting rate over time. Learn more about our strategy or contact our team.
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