Search Results for “"Unstable Value Funds"”

Unstable Value Funds (VII)

Posted on 18 November 2022 by David Merkel

Picture Credit: Boston Public Library || When total systemic leverage is so high, you can’t tell what might go wrong

Because of the fall in interest rates since the last post, the risks have declined with Stable Value Funds. That said, the FOMC still sounds hawkish, even though the yield curve is inverted. The FOMC needs fewer macroeconomists, and more economic historians. They are deluded by the bad models of the last fifty-five years, which lack any credibility outside of the sterility of academia.

Here are the two equations that I left out of the last piece. How to calculate the premium/discount of a stable value fund:

How to calculate the annualized yield to maturity:

Here are the definitions:

BV: Book value — the accrued value of the stable value fund assets so far.

MV: Market Value — the market value of the assets now, if we are able to liquidate the assets at current prices.

AYTM: Annualized Yield to Maturity — the annualized rate that the assets are yielding at current market prices. Note that if you have the SEC Yield, that is the Semiannual yield to maturity, sometimes called the bond-equivalent yield [YTM]. To convert YTM to AYTM:((1 + YTM/2)^2) -1 = AYTM.

D: Effective Duration — The first derivative of Market Value with respect to AYTM. For those that have not taken Calculus, or have forgotten what that means, it measures the sensitivity of market value to small moves in the AYTM. A bigger D means the market value changes more than a smaller D. (And always remember, as interest rates rise, the value of all ordinary bonds goes down.

It is called effective duration, because on a present value basis it measures the weighted average time at which you can expect to receive the cash flows, typically measured in years.

CR: Credited Rate — Though all of these values are artificial in some sense (channeling my best Matt Levine), this one is the most artificial. It means this: in the past the book value accrued to its current value. Now, over the length of time expressed by the Effective Duration, what should the current credited rate be in order for the book and market value to converge? The credited rate is a figure that is like a “heat-seeking” missile, always adjusting (monthly or quarterly) to new conditions as the book value chases the market value. When book value is above market value, the credited rate slows down relative to the AYTM. When the book value is below the market value, the credited rate speeds up relative to the AYTM.
Unstable Value Funds (VI)

As my reader who prompted the last post wrote:

I’m trying to get my head around the implications of the lower MV/BV ratios, but I’m not sure I completely understand the how the crediting rate mechanism works with respect to inflows and outflows.

As I understand it, when MV/BV is less than one, inflows are going bring it closer to par and outflows will further decrease it (assuming outflows are at BV), yes? There are not separate calculations for different plans or different participants, correct? I feel like this may not be a big concern under more typical market conditions, but with MV/BV so low people’s crediting rates are going into look a lot less competitive relative to the returns available with other conservative options and there is more incentive to do as you describe and take the short-term risk in a non-competing fund. Plans leaving is one thing, but a significant participant lead outflow would be much harder to manage, wouldn’t it?

Also, you mention duration longer than 5 being potentially worrisome, but isn’t possible that funds may extend duration early next year as a way of simultaneously goosing the crediting rate and positioning to recoup some losses in anticipation of a Fed pivot? But if rates go higher than expected….
Private email to me

She is a bright lady; she understands it perfectly. Given the recent lower inflation estimates, maybe everything works out easily. But will the FOMC understand that and stop raising the Fed funds rate? Given their desire to appear bold, I think the answer is no. And so I repeat my advice from my last post:

It is not a bad idea now for most participants to move your stable value assets to a balanced fund for 30 days, then move that to a short-to-intermediate term bond fund. You will escape the low-yielding and possibly defaulting stable value fund. You will also earn more from the bond fund.

Remember, there is no FDIC for stable value funds. Watch out for your own best interests while most people don’t notice.

Unstable Value Funds (VI)

Posted on 2 November 2022 by David Merkel

Photo Credit: Ruin Raider || It is important to recognize the limitations of any system. Don’t overestimate what is possible.

Well, the last installment in this series was 2009. I ran a Guaranteed Investment Contract [GIC] desk at Provident Mutual from 1992-1997. I also managed our internal stable value funds for our pension line of business. This was during a period where increasingly Stable Value Funds were being replaced by bonds and bond funds being wrapped by a type of derivative that would allow for “benefit responsive payments,” called a “wrap contract.”

Now, I know I lost most of you with the last paragraph. Definitions:

Guaranteed Investment Contract: A group annuity issued by a life insurance company. It is like a bond, paying principal and interest until it matures. But it is more secure than most bonds because it is an insurance liability, which has a higher bankruptcy priority than a bond issued by the insurance company. Also, a GIC will pay money out sooner if there is a need to pay “benefit responsive payments.” Absent default, the value of a GIC never falls. Its value accrues like a savings account, because it is an annuity from a life insurer.

Benefit Responsive Payments: In Defined Contribution Pension Plans (401k, 403b, 457, etc.), if a participant dies, gets disabled, leaves his current employer, gets served with a QDRO [Qualified Domestic Relations Order — child support, alimony], exchanges funds in the stable value fund for noncompeting funds (funds that are not short-to-intermediate fixed income), etc., then the GIC may pay benefits out early at book value.

Stable Value Funds: Funds that buy investments that absent default, only appreciate, and thus act like a savings account, but with much better yields. Those can be insurance contracts (rare now), or bonds wrapped by “wrap agreements.”

Wrap Agreements: Derivative instruments that receive money if benefit responsive payments occur and the market value of the wrapped bonds is higher than the book value, and pay money if benefit responsive payments occur and the market value of the wrapped bonds is lower than the book value. The objective is that benefit responsive payments go to the beneficiary at book value, and no one else in the Stable Value Fund is affected.

Why am I Writing This?

I received an email from a lady working at a major investment bank, asking me where she could find independent commentary regarding stable value funds, because most of the commentary is produced by the stable value fund managers themselves. Why is that so? Stable Value Funds are complex beasts. Typically only insiders understand them. She was wondering how the funds were doing given the rapid increase in interest rates. This is the toughest scenario for stable value funds.

The Math

Basic Formula of Stable Value by Aleph Blog

Let’s define terms first.

BV: Book value — the accrued value of the stable value fund assets so far.

MV: Market Value — the market value of the assets now, if we are able to liquidate the assets at current prices.

AYTM: Annualized Yield to Maturity — the annualized rate that the assets are yielding at current market prices. Note that if you have the SEC Yield, that is the Semiannual yield to maturity, sometimes called the bond-equivalent yield [YTM]. To convert YTM to AYTM:((1 + YTM/2)^2) -1 = AYTM.

D: Effective Duration — The first derivative of Market Value with respect to AYTM. For those that have not taken Calculus, or have forgotten what that means, it measures the sensitivity of market value to small moves in the AYTM. A bigger D means the market value changes more than a smaller D. (And always remember, as interest rates rise, the value of all ordinary bonds goes down.

It is called effective duration, because on a present value basis it measures the weighted average time at which you can expect to receive the cash flows, typically measured in years.

CR: Credited Rate — Though all of these values are artificial in some sense (channeling my best Matt Levine), this one is the most artificial. It means this: in the past the book value accrued to its current value. Now, over the length of time expressed by the Effective Duration, what should the current credited rate be in order for the book and market value to converge? The credited rate is a figure that is like a “heat-seeking” missile, always adjusting (monthly or quarterly) to new conditions as the book value chases the market value. When book value is above market value, the credited rate slows down relative to the AYTM. When the book value is below the market value, the credited rate speeds up relative to the AYTM.

So what’s the issue here?

Interest rates have risen rapidly, after dwelling at low rates for a long time. Back when I was developing a stable value product in 1996, I knew this was the disaster scenario for stable value. More than most actuaries at the time, I had realistic interest rate scenario models the reflected the true volatility of interest rates. I would create 10,000 full yield curve scenarios over a 10 year period, then analyze the ones where the stable value fund failed. Failures occurred in the scenarios where short rates rose rapidly.

Wait. How can a stable value fund fail? If the credited rate drops below zero, practically it has failed. The fund sponsor will credit zero in such a situation, but it will face the problem of participants exiting to non-competing options, worsening the problem. The stable value fund may not be able to return book value to its participants.

But this isn’t bad for everyone, at least not yet

I don’t think everyone needs to worry, though. The edge cases, those who have taken too much risk at the wrong time should worry. for the worst-managed funds, there is some risk of a “run-on-the fund.”

I did a little digging around the large stable value managers, at least among those who publish all their data publicly. I’m not naming names, I have my own liability risk here. There are a number of insurance companies running their stable value plans at durations higher than 5, and their ratio of market value to book value is near 85%. If you are in such a situation, move your stable value assets to a balanced fund for 30 days, then move that to a short-to-intermediate term bond fund. You will escape the low-yielding and possibly defaulting stable value fund. You will also earn more from the bond fund.

At present, most stable value funds have a market value to book value is between 91-95%. If you are in a fund like that, don’t worry, unless a panic happens because of the funds running at long durations. Then do the same shuffle that I suggest: move your stable value assets to a balanced fund for 30 days, then move that to a short-to-intermediate term bond fund. You will escape the low-yielding and possibly defaulting stable value fund. You will also earn more from the bond fund.

Other Issues

There is also the risk of stretching for yield. Though the bond managers who manage fixed-income portfolios for stable value funds are generally conservative, when rates are low, many bond managers take chances that don’t work out. As such if the YTM/AYTM of the asset manager seems aggressive, maybe pare back. (If it is more than 1.5% above Treasuries, consider leaving.) If something seems too good to be true, it very well may be too good to be true.

Conclusion

Say what you will about Stable Value Funds, they are more opaque than other investments. As such, they deserve more scrutiny. It is not a bad idea now for most participants to move your stable value assets to a balanced fund for 30 days, then move that to a short-to-intermediate term bond fund. You will escape the low-yielding and possibly defaulting stable value fund. You will also earn more from the bond fund.

I don’t think most people have to do this, but it is not a bad strategy for all. Take your opportunity and move stable value money to a balanced fund. Then if you don’t like the volatility, move to a short-to-intermediate term bond fund.

Unstable Value Funds (5 – CMBS Edition)

Posted on 2 June 2009 by David Merkel

Over the last two months, the assets underlying most stable value funds have done well, and short ABS, CMBS, and RMBS bonds have rallied.? Insurance debt as well.? But just when you think you can relax, S&P comes in to jolt confidence.? Here are some articles:

You don’t have to read all of these.? The main ideas are:

Super-senior AAA CMBS is not bulletproof.? From the S&P report, “In particular, 25%, 60%, and 90% of the most senior tranches of the 2005, 2006, and 2007 issuances, respectively, could be downgraded.”
Some view S&P’s new criteria as draconian.
Rents from properties underwritten in the boom period 2005-7 are definitely declining.?? The stress tests impose a 25%-ish haircut for rents in everything but multifamily, whose haircut would be around 6%.? These would be adjusted for geography and quality.
Prior to the announcement the quote? in Markit CMBX AAA 4 — 2007 super senior exposure was in the low $80s.? Now it is in the low $70s.
That’s more than a 1% move up in yields.
Many maturing loans will not be able to refinance at the same principal levels.? Property owners will need to feed the properties, and equity capital is scarce.
This undermines the Fed?s efforts to expand the TALF to some legacy CMBS that will be downgraded below AAA.

There’s one more knock-on effect.? This review by S&P will also incude a review on how CMBS Interest Only [IO] securities will be rated.? The old philosophy was “Since IOs have no principal, they can’t lose principal, and securities that can’t lose principal are AAA.”? But when I would review CMBS securities 1999-2001, my models would indicate credit risk akin to BBB or BB securities.? Underwriting standards were much higher back then, so the new ratings for CMBS IOs will likely range between BBB to CCC.? Think single-B and below for vintages since 2005.

Though it won’t change the underlying cash flows of the CMBS IOs, it will change the ability of regulated financial institutions to hold them, particularly if Moody’s and Fitch follow along, which I think it makes sense to do.? With lower ratings, financial instutions will have to hold more capital against them, which lowers their desirability.? The regulatory arbitrage goes away.

So what then for Stable Value funds?? It’s a PR, marketing and a liquidity issue.? AAA CMBS plays a large role in stable value, particularly the short stuff that could be financed by the TALF.? If TALF is off the table, then prices have slipped considerably.? That doesn’t affect cash flows of the securities, but it? does mean that:

The difference between book and market widens.
Any SV fund with a need for liquidity can’t find it in their CMBS, because it is likely below the amortized cost.
There will be optical problems for current and prospective clients as they see the credit quality of the SV fund decline.
Those with a significant allocations to CMBS IOs (I hope there aren’t any) will see those assets go to junk, fall in current value, and be even harder to trade.

This is just another issue for Stable Value Funds — by itself, it is not likely to be enough to break the funds.? That would require something really nasty, like a quick run upward in short- and intermediate-term interest rates, or credit stress beyond this.? For the former to happen would require the FOMC to begin tightening, and absent a major dollar panic, they are not doing that anytime in the near term.? As for the latter, we have not yet seen the impacts from Alt-A recasts and resets, and the declines in commercial property values.? We will wait, pray and see.

Unstable Value Funds? (IV)

Posted on 7 March 20098 March 2009 by David Merkel

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
AEGON
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.

Unstable Value Funds? (III)

Posted on 5 March 2009 by David Merkel

There’s a lot that I don’t know here, but what I do know concerns me.? Stable Value funds are a murky part of the market.? They are murky because they don’t report the value of the underlying assets, but only the smoothed value of assets, and the rate that they are currently crediting.? (Note: for those that want the grand tour of Stable Value Funds, I wrote this piece at RealMoney, The Biggest Asset Class You Never Heard Of.

Unstable Value Funds? (II)

Posted on 9 January 2009 by David Merkel

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:

Unstable Value Funds?
A Maximum of One Year of Interest Lost
A Proposal for Money Market Funds, and More and,
The Biggest Asset Class You Never Heard Of (comprehensive article, at RealMoney)

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.

Unstable Value Funds?

Posted on 18 January 2008 by David Merkel

		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.

Stable Value Versus Rising Rates

Posted on 7 April 2013 by David Merkel

If you own a short-to-intermediate term bond portfolio, and you did not need to tap the cash for a few years, would you prefer rising short interest rates, or falling rates?? The correct answer is rising rates, because you will be able to reinvest interest payments paid in higher yielding securities.

That’s why I take issue with the following article on stable value funds from the Wall Street Journal.? Some might remember my “Unstable Value Funds” series.? Though the worst never happened, many funds came close to “breaking the buck.”

I once designed a substitute for Stable Value Funds, one that could trade on Schwab’s platform.? But the math of the product meant that it could be blown apart by a very rapid rise in short rates.? To try to remedy that, I rewrote the pension services contract to put in? a Force Majeure clause that would allow? the insurance company to alter many terms of the contract to avoid “breaking the buck.”?? (In 1997-8, I thought ahead, and designed a contract that had modes for normal and abnormal environments. Hey, Nationwide Insurance, it’s your intellectual property now. Use it.)

My main point is that stable value funds will lag in a rising rate environment.? Yes, it will not appear that you are losing money in the short run. but the credited rate will lag for 2-3 years, while returns to the short-to-intermediate term bond portfolio will be hurt in the short-run, but do well in the intermediate-term.

Be wary.? Even though Stable Value funds do not face credit risk problems now, rising rates would invite anti-selection by making short-to-intermediate term bond funds look attractive, even with the 90-day switch into equities or longer bonds.

Remember, Stable Value funds are bond funds that pay a little extra to guarantors, so that payments for death, disability, fund switching, etc., go out at book value.? They have to pay the fund management fees and the small guarantor fees.? The short-to-intermediate term bond fund can invest a little more aggressively, and only has to pay out the management fees.? Over the long haul, the short-to-intermediate term bond fund will beat most Stable Value funds, but the ride will seem more bumpy, because except in the worst scenarios, the Stable Value fund acts like a savings account, slowly accruing value, while the underlying investments actually behave like a short-to-intermediate term bond portfolio, with all of the volatility.

The Best of the Aleph Blog, Part 4

Posted on 3 February 2011 by David Merkel

The period from November 2007 through January 2008 was challenging, but I did say a lot of good things.? Here’s a sample of the best:

Contemplating Life Without the Guarantors

Markets always beat governments, unless governments get so determined as to subvert markets.? Guarantors provide “thought insurance” so you don’t have to analyze the bond that they guarantee.? But what if the solvency of the guarantor is questioned?

The US Dollar and the Five Stages of Grieving

An important article that explains why currency interventions almost never work.? Required reading for Treasury Departments and Central Banks.

Why Did I Name This Site ?The Aleph Blog??

Cogent explanation for the odd name.? But I have gotten the question a few times as to whether I named my site after Jorge Luis Borges short story, “The Aleph.”? The answer is no, but after reading “The Aleph,” I would say that it folds into reason number four for why this is called The Aleph Blog.? Aleph is big.? Very, very big.

On the Value of Secondary and Primary Markets

They are valuable for different reasons, but they are related.

In Defense of the Ratings Agencies

The original piece, pointing out how the regulators have abandoned their responsibility, having outsourced it to the rating agencies.

Personal Finance, Part 6 ? The First Question

How much are you willing to learn, and how much work do you want to do? For people who ask my advice, that is usually the first question that I ask.

Booyah for Brainy Buybacks! (But not Brain-dead Buybacks.)

There is no simple answer to whether a buyback is the right strategy or not.? It depends on the price of the stock versus its value.

Options as an Asset Class

You can own/short options, but you can’t own/short volatility per se, at least not back in 2007.

Municipal Tensions

We are experiencing the front end of the woes now.? This won’t be over for 20 years.

How to Read the Whole Bible, and Survive the Experience

A simple way to read the whole of the Bible, and avoid getting bored, as so many do who try to read it straight through, and give up when 10-50% done.

In Defense of the Rating Agencies ? II

Anyone can criticize, but who can offer a system that is better than the present one on a comprehensive basis?

The Beauty of Broken Moats

Berky had an opportunity with almost all of the financial guarantors kicked to the curb.? It never worked out because Berky would not take modest risks.? In foresight today, those modest risks don’t seem so modest, so salute Mr. Buffett, who has forgotten more than most of us will ever know.

What Did Buffett Know about the Gen Re Finite Reinsurance Deal with AIG?

Odds are, Buffett knew a lot more than he confessed to know.? Buffett is a maven on insurance issues.

On Benchmarking

Benchmarking enforces conformity on managers, and the shorter-term the horizon, the more it makes them closet indexers.

Pandora and the Fair Value Accounting Rules

There are really tough issues here.? Everyone wants to be accurate, but over what time horizon, and how to adjust over time?? Bright investors will build in provisions for adverse deviation, and be conservative.

Unstable Value Funds?

This didn’t prove to be an issue, in this credit cycle, though form what I heard from insiders, it got close.? If the Fed hadn’t done 0% and QE, my dire predictions might have come true.? They still might in the future.? Be wary.

Meet Some of my Friends

Though the videos have disappeared, the story of how President George W. Bush, Jr. came to visit the factory of a friend of mine (of which I own 1.4%) is an interesting tale.? I was proud of my friend, who is a humble, but a great guy.

A Bonus from MoneySense Magazine

A free version of what Canadian magazine buyers had to pay for. How to earn more while taking less risk.

Personal Finance, Part 11 ? Your Personal Required Investment Earnings Rate

The intuitive explanation of what you need to earn in order to achieve all of your life goals.? It’s probably higher than you think.

With 401(k)s and Other Defined Contribution Plans, Watch Your Wallet

An important article — from the article:

If you are paying more than 1% of assets per year, then something is wrong, unless the asset classes are esoteric, which should not be the case for DC plans.? Remember, you have to be your own guardian with defined contribution plans.? No one will do it for you.? And, if a few of your colleagues complain at the same time, you will be amazed at how quickly it will be taken seriously, because the administrative staff of the plan sponsor usually doesn?t get that much feedback.

In general, high costs are closely correlated with low performance.? Keep a close hand on your wallet, and leave those who are charging you more than 1%, unless they are doing something special for you.

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I think I gave good advice in that era.? As the bubble deflated, investors needed to be more careful, and I highlighted that.? Not that I will always get it right…

Choose Two: Principal Protection, Liquidity, and Above-Market Returns

Posted on 5 May 2009 by David Merkel

Two pieces worth reading today from Eleanor Laise at the Wall Street Journal, which go along with what I have been writing in my Unstable Value Funds series:

I just want to make the short, simple point that an investor can only get two of the following three items (at best):

Principal Protection
Liquidity
Above-Market Returns

Perhaps I am a bit of a pessimist, but as a wide number of products came into existence attempting to offer all three back in the 90s, I would ask questions like, “But what happens if you have losses on assets and redemption requests at book at the same time?”? An answer would come back on the order of, “You worry too much.? We’re making money.”

True, as parties are willing to take more and more risk, you can get all three for a time.? But over a full market cycle, it can’t be done.? And, by a full market cycle, I mean a period of time long enough to include a major debt deflation, like the 30s and now.

So, be aware of withdrawal provisions on your investments, both the formal ones listed in the prospectus or its equivalent, and the informal ones where ability to withdraw is suspended as a matter of fairness to all clients, and/or protecting a business at a financial firm (though risking lawsuits in the process).

Also, try to understand what underlies the shares in any pooled investment vehicle that you own.? If the underlying does not have a liquid secondary market, the shares of the pool won’t be liquid under all conditions.? If the value of the assets vary considerably over time, stability of principal won’t be possible under all conditions.

So, be aware.? Though there are laws and courts, you are your own first and best defender when it comes to any investments.