Unstable Value Funds? (IV)

This should be my last post on this topic for a while.  I thank those that sent me additional data that agreed with my theses in the piece Unstable Value Funds? (III).  I would like to start by quoting from my piece at RealMoney The Biggest Asset Class You Never Heard Of.

The bonds held in stable value funds can’t be valued at book value, because accounting rules require that they be held at market. The stable value pool goes out and purchases derivatives known as wrap agreements in order to allow the bonds to be held at book value. The wrap agreements agree to pay or receive money if any of the bonds have to be liquidated at a loss or gain respectively, thus making the fund whole for any book-value loss.

Typically, wrap agreements are only done on the highest-rated bonds, AAA, so credit risk is not covered by most wrap agreements. With most wrap agreements, once a payment is received or made by the wrapper, the wrapper enters into a countervailing transaction with the pool to pay or receive, respectively, a stream of payments over the life of the bond that was wrapped equal to the present value of the initial payment when the bond was tapped. The wrapper bears almost no risk in the arrangement; the risks are rated back to the stable value pool, and the stable value pool pays for the gains and losses through an adjustment to the pool’s credited rate. Because wrappers bear almost no risk, wrap pricing in 401(k)-type plans is typically 0.05%-0.10% per year of assets wrapped. The only risk a wrapper faces is that the interest-rate-related losses on a bond in a rising interest rate scenario are so severe that the losses can’t be repaid out of the yield of the wrapped bond. In this case, the wrapper would have to pay without reimbursement.

Interest Rate Risks

Stable value funds attempt to maintain a stable share price, but the assets underlying the fund vary as interest rates, prepayment behavior and credit spreads change. There is almost always a difference between the book value of the assets, expressed by the NAV, and the market value. When the stable value fund has a higher market value than book value, typically it pays an above-market yield. There is a risk that in an environment where interest rates have risen sharply, a stable value fund would have a lower market value than book value, with a below-market yield. In a situation like this, particularly when the yield curve inverts, there is a risk that shareholders in the stable value fund will leave in search of higher yields. If that happens to a high degree, it will worsen the gap between the market value and book value of assets. That gap will be covered by the wrappers in the short run but will reduce the fund’s yield as it pays the wrappers back. It is unlikely but possible to get a death spiral here if more and more shareholders leave the pool and the yield sags to zero. It hasn’t happened yet, so this is theoretical for now. In theory, the wrappers would keep paying once the fund’s credited rate dropped to zero, so no one would lose money unless a wrapper defaulted on his obligation. There probably would be some legal wrangling in such an event; the wrappers might try to get the fund manager to take on some of the liability, or negotiate down the amount owed, leaving policyholders with a loss. In 401(k) plans, there are limitations on transferring funds out of a stable value fund to funds that would offer an easy arbitrage, so the risk of a death spiral is further reduced but not eliminated.

Asset Default Risks

For the most part, stable value funds take little credit risk, but it’s little known that this is not universally true. Some of these funds buy corporate bonds or other, more riskily structured product bonds. Some of them take credit risk in hidden ways. For example, there are some exotic, asset- or commercial-mortgage-backed interest-only bonds that are rated AAA by the rating agencies. The agencies rate them AAA because they can’t lose principal; they have no principal to lose. But if the loans underlying the interest-only bonds default or prepay, the interest stream gets shortened. The sensitivity on these securities to default risk is more akin to BB or BBB bonds, but a manager using them can count them as AAA. If an asset in a stable value fund defaults, the fund probably will temporarily suspend withdrawals while the managers pursue one or two courses of action. If the loss is small, its managers might buy a wrap contract for the loss, which will give a haircut to the yield on the stable value fund for the life of the wrap contract. If the loss is big, they will reduce the NAV and attempt to keep the NAV stable from there. Given the history of money market funds breaking the buck, it is possible that the fund manager might pony up the funds to make the stable value fund whole, but I wouldn’t rely on that.

I want to publicly thank Chris Tobe for writing to me.  He brought me back up to speed on some aspects of stable value that I was not in touch with.  (Any errors here are mine, not his.)  After reading what he sent me, there are two major risks.  One I have described in-depth: credit risk.  The other I described in my RealMoney piece: wrapper risk.

When the market value of assets is lower than the book value of assets, the wrapper covers the difference when withdrawals are made.  But the difference typically gets amortized into the credited rate of the stable value fund, lowering the interest rate credited to pay back the wrapper.

But what if the interest rate were forced to zero?  Then the wrapper would take losses.  Investors take losses is if the wrapper is insolvent when book value is more than market value.  The stable value fund could try to replace the wrapper, but it will come out of the hides of investors, unless the management company bears it.

There aren’t many wrappers today.  Here’s a list:

  • JP Morgan
  • State Street
  • RBC
  • CDC
  • ING
  • Pacific Life
  • AIG (few buying from them)
  • Rabobank (not accepting new business)

As such, with the current financial stress, wrap fees have doubled.  There is more need for wrap capacity than is currently available.  There is the potential for losses as wrappers could go into insolvency.

But how big is this problem for investors?  The stable value marketplace is very big, though the severity of any loss should be small — under 10% of capital on average (some could be worse than 10%).

There are two troubles here.  First, because the stable value industry does not reveal the market value of their assets under management.  The opaqueness adds to the mystery.  Second, because the stable value funds have more accounting flexibility than most investment options, they can wait much longer than a money maket fund, which must declare a credit event if the NAV of the MMF is under 99.5%.  There is not such a threshold for a stable value fund.  The risk is that a stable value fund engages in wishful thinking, assuming that the value of their bonds will rebound, and the rebound does not happen.

Is a loss of 5% horrible, in an investment that is supposed to be safe?  How about 10%?  20%?  I can’t go over 20%, the fund managers must act by then.

It is likely that losses will be small in the stable value option, but losses are a real possiblity.  Transferring assets to other fixed income options or other stable options could be smart.