If you could purchase an intermediate-term bond fund with no risk of negative returns, wouldn't you be interested?
Stable value funds, also known as capital preservation, interest income or principal stability funds, seek to provide positive returns regardless of market conditions. However, the U.S. Securities and Exchange Commission has announced that it is investigating one type of stable value fund, leading some to conclude that stable value may end up extinct. While such conclusions are premature, investors should take a closer look at their stable value funds. There is no such thing as a truly guaranteed return, and investors who assume that their funds are infallible may be in for a few surprises.
Stable value funds generally invest in portfolios of high-credit-quality, short-term fixed-income securities and guaranteed-interest contracts (GICs) from banks or insurance companies. The funds are able to protect their portfolios against interest rate risk by purchasing insurance wrappers. If the market value of the fund portfolio drops below a certain level, the insurer steps in and pays the difference to keep the fund's net asset value (NAV) constant.
Stable value funds can be purchased only in tax-advantaged accounts such as 401(k)s, Section 529 Plan accounts and Individual Retirement Accounts (IRAs). According to the Stable Value Investment Association, $321 billion of stable value assets are held in 401(k)s, compared with $6 billion in IRAs. Similar to money market funds, stable value funds maintain fixed NAVs and make periodic dividend payments. However, stable value funds are able to purchase securities with longer durations and higher yields than money market funds, which leads to a higher expected return with the same low volatility.
SEC Investigates Two Issues
The SEC is investigating only stable value mutual funds, which are generally available in IRAs. Stable value funds offered in employer-sponsored 401(k) plans are regulated by the Labor Department, and will not be affected by the SEC investigation. The SEC is looking into two issues with stable value mutual funds: the accounting methodology used and the possible lack of proper disclosure and investor familiarity with the product.
The SEC has questioned why stable value mutual funds are able to reflect static NAVs, even though the value of their underlying portfolios changes each day. While the mutual fund companies say that the insurance wrapper justifies the fixed NAV, the SEC is looking into the accounting methods the fund companies use to value their wrappers.
Because stable value funds have only been in existence during a period of falling interest rates, insurers have rarely had to step in to maintain a fixed NAV. Because insurers believed the probability of having to meet an obligation to a stable value fund was low, they charged very low premiums. Critics maintain that insurers have underestimated the potential liabilities on their balance sheets. The SEC seeks through its investigation to better understand the accounting methods the insurers use.
Many investors are not aware of the risks involved with their stable value funds. The first lesson that any investor should understand is that only the insurer guarantees the fund's NAV. It is not guaranteed by the fund company, the federal government or any other entity. If a fund buys insurance from a fly-by-night insurer, and the insurer is unable to fulfill its obligation when called upon, the investor will suffer a loss of principal. A second consideration is that some insurance wrappers do not protect against the default of a fixed-income security in the fund portfolio. Investors should be skeptical of a stable value fund that offers a higher yield than its peer group. The fund may be buying bonds from issuers with low credit ratings. This could lead to defaults that may not be covered by the insurer.
The main issue, which should concern both the SEC and individual investors, is the potential consequences of rising interest rates. A disturbing scenario could unfold: As interest rates increase, the values of bonds fall and debt issuers become more likely to default. The mutual fund companies will call upon insurers to step in and maintain a fixed net asset value. Investors in stable value funds that have not purchased proper insurance coverage may lose substantial amounts. In addition, insurance premiums for stable value fund insurance wrappers may become prohibitively expensive, leading to either reduced investment returns or the conversion of stable value funds to more traditional fixed-income funds. Two mutual fund companies (Principal Financial Group and PBHG Funds) have already converted their stable value mutual funds into traditional fixed-income funds, citing as a major factor concerns about rising insurance premiums.
Should The SEC Eliminate Stable Value?
Stable value funds are attractive as long as they are able to fulfill their promises to investors. To protect yourself, we recommend taking a closer look at any stable value funds in your portfolio. It is important to evaluate the stability and number of insurance providers that the fund is using. It is also important to evaluate the creditworthiness and fair market value of the fund's portfolio. If the fair market value of the fund's portfolio is lower than the insurance wrapper amount, you stand to lose principal if the SEC revokes wrappers. Finally, be aware of movements in interest rates and the bond markets, and how they may potentially affect your stable value fund.
Investors who own stable value funds only in their 401(k)s also should monitor these funds, as well as the SEC investigation. While the SEC does not regulate investments held in 401(k)s, its findings on stable value funds could have a long-term effect on this asset class. Fund companies with stable value products available only in 401(k)s may also choose to adhere to any new rules or regulations for stable value mutual funds.
Palisades Hudson Asset Management, Inc., has used only one stable value mutual fund, the Scudder PreservationPlus Income Fund, for its clients. The fund purchases insurance wrappers from seven different insurers, all with financial strength ratings of AA+ or AAA, and the average credit quality of the fund's portfolio is AAA. In addition, according to Scudder, the fair market value of the fund's portfolio is greater than the insurance wrapper amount, meaning that the fund's NAV (currently fixed at $10.00 per share) would actually increase if wrappers were revoked.
While some believe that the SEC will put an end to the funds, others have recommended more regulation. A reasonable approach may be to regulate stable value mutual funds in a similar way to money market funds, which are required to construct portfolios according to certain quality, maturity and diversification standards. No such rules currently exist for stable value mutual funds. For the funds to continue, the SEC may impose similar standards, as well as standards for the insurance wrappers that the funds purchase.
The diversification and risk/return characteristics of a properly operated stable value fund are attractive, and there is a place for stable value in some investors' portfolios. These funds will be particularly appealing to the coming wave of retirees, who may have an aversion to risk but also will be looking for high yields on their investments. However, all investors should recognize the risks involved, and monitor their stable value investments as they would any other investment.