Unstable Value Funds?

David Merkel
Things That Go “Bump” in the Night
1/17/2008 1:45 PM EST

One piece that I wrote three years ago for RealMoney has relevance today in a new way. Stable Value Funds often invest in AAA securities (some are solely invested in AAA securities), and some funds will have above-average exposure to securities credit-wrapped by the financial guarantors, and possibly, to some asset-backed securities that were rated AAA at issue, but don’t deserve that rating now. For those who have exposure to stable value funds through their defined contribution plans, it might be wise to check what exposures your funds have to the guarantors, and to AAA structured securities that are trading significantly below amortized cost. The summary statistic to ask for (not that they will give it to you) is the market-to-book ratio of the fund. If it gets lower than 97%-98%, I would avoid the fund.

Now for the good news: If a stable value fund breaks, the total loss is likely to be small, like that of a busted money market fund. The one exception would be if a stable value fund manager tried to meet withdrawals while facing a run on the fund, and ratio of the market value of the assets to the book value of the assets kept falling.

In such an event, better for the fund manager to stop withdrawals early and announce a new NAV that counts in the loss.

I don’t know of any stable value funds that are in trouble, so take this with a grain of salt. Most stable value funds are managed conservatively, so any testing will likely reveal that most of them are fine. There may be a few that aren’t fine, though, so a little testing is in order.

If you do find a need to move, money market and high quality bond funds are an excellent substitute for stable value funds. Be aware that you might have to leave funds in a non-competing fund option for 90 days to get there. In this market, the risks there could be as great as the losses on the stable value fund, so think out the full decision before making any change.

Position: none

That was my post at RealMoney today.  I wrote it with some degree of uncertainty, because stable value funds have a defense mechanism.  They can lower the crediting rate to amortize away the difference between book value and market value, and in a crisis, many will not argue with the credited rate reductions.  They are just happy to preserve capital.

Do I think this is a big problem?  No.  Do I think that no one is talking about this?  Yes.  The thing is, a lot of things can be hidden by the various wrap agreements that stable value funds employ.  If I were a stable value fund, I would not want to publish my market value to book value ratio.  If it’s above one, the fund will attract inflows, diluting existing investors.  If it’s below one, net outflows will increase, threatening a run on the fund.

Just be aware here, because if you can’t get a feel for the underlying economics of your stable value fund, you should probably seek another investment in the present environment.