How Rising Interest Rates Affect Stable Value Funds
Since stable value funds invest in intermediate-term bonds and money market funds favor short-term bonds, the recent rise in short-term interest rates has been creating some challenges for stable value funds.
Experts say, however, that this condition is cyclical, and stable value funds still hold great appeal for retirement plan sponsors and participants.
“The interest rate environment over the past 12 months has been very challenging for stable value funds,” says Jonathan Kreider, vice president of investment products at Great-West Financial in Greenwood Village, Colorado. “One headwind has been the general flattening of the yield curve, which is cyclical.”
Another headwind, according to Krieder, is “more structural.” He says the long-running bull market in equities has left investors in general less focused on defensive funds and capital preservation.
“All bull markets come to an end,” he warns.
John Faustino, chief product and strategy officer at Fi360 in Chicago, agrees that while the increase in short-term interest rates can make stable value funds “a little bit less attractive” than money market funds, in his experience this is usually a short-lived phenomenon.
“It is true that rising short-term interest rates could create yields in money market funds that exceed those of stable value funds,” Faustino says. “Over the past 50 to 60 years, there have been 10 times when the yield curve inverted, whereby three-month Treasury yields, more similar to money market durations, have been higher than five-year Treasuries, more similar to stable value duration.”
What is important to note, he says, is that when those inversions did occur, they only persisted for five to six months.
“Since many stable value funds have provisions that require a plan sponsor to give 12 months’ notice before moving to a competitive product, it likely won’t make any sense for a plan sponsor to move,” Faustino says.
Kreider says it is also important to note that, if increases in interest rates occurs slowly over time, stable value funds’ crediting rates will be responsive to this.
“There will be fewer losses in the underlying bonds, so the crediting rate is unlikely to decline,” he says. “If the interest rate move is rapid, however, crediting rates might actually drop in the face of higher interest rates.”
Additionally, the experts agree on the importance of being aware of the fact that, while stable value fund returns can fall behind those of other products invested in short-term bonds, generally speaking the lag is quite temporary compared with the long-term investment horizons of retirement savers.
Gary Ward, head of stable value at Prudential Retirement in Newark, New Jersey, says that the recent market volatility should be a reminder to plan sponsors and participants of the critical role that stable value funds offer them. Since stable value funds offer steady returns with guaranteed principle, participants may want to include them in their portfolio, he says.
“In times of market volatility, it’s an opportune time for individuals to review their asset allocation, to ensure they have a diverse portfolio that aligns with their investment needs, and rebalance as necessary,” Ward says.
Additionally, with interest rates now rising, it is important to be aware that stable value products are built to be responsive to rate increases without volatility in the returns, Ward says. “Stable value products are built for different market cycles and interest rate conditions, offer long-term benefits and are ideal for long-term savings vehicles like defined contribution plans.”
When considering a stable value fund, sponsors and advisers should conduct a thorough due diligence process, Kreider says. This includes looking at “the credit rating of the issuer, the composition of the investment portfolio, the capital and reserves available to support guarantees, the historical crediting rates of the portfolio, termination provisions and any potential recordkeeping reductions associated with the use of the product.”