Since they are designed to protect investors against declines in interest rates or drops in asset values, stable value funds—and the “wrap issuers” that insure their portfolios of high-quality corporate and government bonds—have drawn considerable scrutiny from institutional investors amid the current market turmoil.

Unlike the 2008 Global Financial Crisis, stable value managers are not experiencing limited wrap capacity and large negative swings in their market value-to-book value ratios. Wrap issuers are continuing to take in deposits and do not show signs of stopping, or changing contract provisions. The wrap issuer industry is healthier than it was in 2008, comprised of issuers with stronger balance sheets as well as insurance companies better informed of the risks than the banks and insurance companies that exited the wrap industry during the GFC. Also, stable value investment guidelines have become more stringent since the GFC, disallowing the illiquid and below-investment grade securities that wreaked havoc in some stable value portfolios in 2008.

Generally, liquidity buffers have increased given a surge of inflows from plan participants. Recent wide bid-ask spreads do not appear to have negatively impacted the managers’ abilities to run their strategies. They do appear to be cautious about where they put money to work. Some are opportunistically adding to high-quality corporate bonds within the new issue and secondary market, as well as securitized fixed income. Stable value managers are generally expecting crediting rates and market-to-book ratios to move lower, but remain above par. Note that crediting rates are typically reset at month end.

While stable value funds are not showing GFC-level signs of distress, institutional investors should still monitor them closely. We advise that investors focus on these key issues:

• Surge of cash inflows: Investors should monitor how their fund has managed a sharp rise in participant contributions. Investment guidelines typically limit a manager from extending duration outside of a defined band, often two to four years. A lower bound may force managers to use new cash flows to extend the portfolio’s duration by investing in longer-dated securities that are not attractive from a risk/reward perspective. This is also true if there is a reference benchmark to which the fund may be constrained.
• Duration range: Investors should also monitor efforts to stay within the typical two- to four-year range. Duration plays an integral part in the return “smoothing” aspect of stable value funds, because variations in the market-to-book surplus or deficit are typically amortized over the duration of the portfolio (i.e., two to four years). Managers have noted liquidity buffers have increased, which would indicate that portfolio durations have decreased.
• Wrap issuer stability: While the wrap market may be robust, the financial stability of individual providers may deteriorate at the end of a market cycle. A stable value manager should be able to “sub-in” a wrap provider if one of its issuers exits the market. Managers generally maintain a list of approved providers and should readily provide this list to clients.
• Asset guidelines: Investors should address how the wrap contracts respond to assets that violate guidelines and what the impairment bucket language states. These contract provisions are important because they can help clients weather a storm, or expose them to additional risk through forced selling.
• “Cure periods”: A wrap contract may include a cure period provision that is triggered when asset allocation guidelines are violated. We typically prefer longer cure periods, generally 90 days, allowing the manager to bring exposures back to compliance. Cure periods should differ by sectors given individual bond markets may behave differently.
• Impairment bucket: This tranche allows a manager to hold an investment that has been downgraded to a BB or B rating; we generally see a range of 5%-10% of the portfolio.
• GICs: Investors should check whether their stable value portfolio includes concentrated counterparty risk (such as traditional guaranteed investment contracts (GICs)). The credit exposure from a traditional GIC is high relative to a synthetic GIC because under a synthetic GIC if the issuer defaults, the institutional investor still retains ownership of the underlying assets for benefit responsiveness. Should a traditional GIC issuer become insolvent, the payout depends on the economic value of the insurer’s asset portfolio as well as the treatment of traditional GICs in the creditor classification structure. In a portfolio, a traditional GIC typically represents a bigger single-issuer exposure relative to a corporate bond issuer.
• Wrap structure: Certain stable value wrap structures may introduce obstacles to replace a wrap issuer that exits the market. Under a segmented wrap structure, stable value managers have the flexibility to swap issuers wrapping a dedicated portion of the underlying assets. For example, a single wrap issuer may contract to provide coverage over the one- to three-year government/credit bond fund. Under a global structure, a set of wrap providers contractually agrees to cover an entire portfolio at set percentages instead of a specific portion of the assets. Due to this contractual arrangement, should one of the global wraps stop taking assets, then all the wrap providers may have to halt, or be required to take on a larger portion of the portfolio. A manager should be able to bring in a wrap provider from its bench in this scenario. Otherwise, a “step-up” provision helps mitigate this scenario by allowing the rest of the wrap providers to divide the percentage left by the exiting wrap provider. For example, a structure can have six wrap providers each underwriting 16.5% of the coverage. If one provider exits the business, the other five have contractually agreed to increase their coverage to 20%.
• Expelled assets: What happens if a given portfolio wrapper expels an asset from the wrap, but the others won’t take it on? In these cases, a stable value manager will need to put it under a new wrap contract; otherwise it may negatively impact stability of the NAV.
• Closing off funds: Investors should be informed if stable value managers would seal off a pooled fund from new cash flows if wrap capacity dries up. After the GFC, some managers closed their CITs to new plans. This was a good move as they protected current clients during a period of very high market-to-book ratios and limited wrap capacity as issuers exited the business. Inflows pull down a market-to-book surplus; at very high flow levels it is diluted more quickly. Given wrap capacity was limited and reinvestment rates were low, the managers would have been stuck with parking new plan assets into cash, dropping duration and return potential. Therefore, a stable value manager should be prepared to answer how it would respond to prospective client assets in the event that wrap capacity dries up.