Unstable Value Funds? (II)

Well, here’s a first crack in the foundation for stable value funds.  From the article:

The $235 million Lehman vehicle, though, lost 1.7% in value in December because bond prices fell and the insurance backing, called a “wrap” in financial parlance, ended after Lehman’s mid-September bankruptcy filing.

The reason is tied to the wrap agreements negotiated for at least two of the fund’s seven insurance providers, Pacific Life Insurance Co. and J.P. Morgan Chase & Co. Since the full coverage was no longer effective, Invesco severed the arrangements with them.

The 1.7% loss was subtracted from Lehman investors’ accounts, so fund investors ended up receiving about 2% in interest in 2008. The entire situation is causing a stir among stable-value investors, who fear that it may spread to their funds if more bankruptcies crop up. Of course, the shortfall doesn’t come close to the 39% decline in the Standard & Poor’s 500-stock index last year.

The Lehman fund’s 1.7% loss is a rare occurrence in the $416 billion stable-value industry, which has had few problems in its 35-year history. More than half of 401(k) plans in the U.S. now offer stable-value funds.

Stable value funds do have credit risk.  That credit risk is often spread among AAA and AA corporate names, and among the financial guarantors, MBIA and Ambac, and GSEs like Fannie and Freddie, back when they had those ratings.

Often, Stable value funds would purchase mortgage bonds guaranteed by Fannie, Freddie, or one of the guarantors.  They would then purchase a wrap to guarantee that benefit-responsive payments would be made at par, not at market value.  All fine, except that the wrap might not last as long as the mortgage bond in a rising interest rate scenario, or that the guarantor might default.  The former happened this time.

I’ve written about stable value funds before:

Stable value funds dodged bullets with Fannie and Freddie.  They still have issues with MBIA and Ambac, but the jury is out there.  There is one more major risk area for stable value funds: rapidly rising interest rates.

In a situation where short-term interest rates rise rapidly, the crediting rate of the stable value fund will lag the rise significantly, leading some to withdraw when the market value of the fund is less than the book value, leading to a possible run on the fund.  Now my proposal, A Proposal for Money Market Funds, and More, could deal with the problem, but that’s not in any of the contracts that I know of.

This is not to scare you out of stable value funds — after all, in a bad market, what does worse?  Stocks or stable value?  Stocks, of course.  But where you can move to other options that are more palatable, like short-term bond funds, money market funds, etc., it could be a good move.  Even a blanced fund or a corporate bond fund could work in this environment.

Be aware, and pressure your DC plan providers for more data on the stable value option.