Structure matters - A differentiated approach to stable value investing

Executive summary

• Typical stable value funds are structured to focus on total return, often resulting in less flexibility to meet unexpected liquidity needs.
• By rethinking traditional stable value design, we argue that a differentiated structure is preferable, one that better balances both total return and liquidity needs.
• We introduce an approach to stable value investing that reduces withdrawal risks, leads to more stable crediting rates, and provides managers with greater flexibility to enhance overall portfolio returns.
   

Introduction

Stable value strategies seek capital preservation, aiming to generate consistent long-term performance while ensuring that participants can trade at book value, regardless of the underlying market value of the assets held in the fund. To meet these objectives, most fund managers simply use their standard total return fixed income strategy. We believe managing Stable Value in this way ignores the importance of having flexible liquidity which can mitigate the risk of excess withdrawals which can negatively affect the future return experience.

In our view, a fund structure focused on liquidity that mitigates this risk is essential to appropriately managing this asset class and improves the probability of delivering a best-in-class participant experience with stable value. Here we explore how stable value funds are commonly structured and how a liquidity-first approach—driven by multiple types of book value investments—can lead to superior long-term outcomes.

What are the primary building blocks of stable value funds?

Stable value funds can consist of three components: Cash buffer and cash alternatives, synthetic Guaranteed Investment Contracts (synthetic GICs or “wraps”), and contracts issued by insurance companies, generally known as traditional Guaranteed Investment Contracts (GICs).

Cash buffer

Most funds maintain a minimum cash buffer to handle participant withdrawals and transfers. In environments where cash is not attractive from a return perspective, funds may choose to have lower cash levels. Conversely, if there is an environment that is more favorable to higher cash allocations, such as an inverted yield curve environment, funds may hold higher allocations to not only increase return in the short run, but also have a greater amount of liquidity (“dry powder”) in the portfolio to seek opportunities when longer-term rates become more attractive.

Synthetic GIC

A synthetic GIC consists of an underlying portfolio of assets, owned by a trust or plan, and a legal contract with an insurance company or bank. The wrap contract allows participants to transact at book value, also referred to as amortized cost, for qualified withdrawals. This means participants transact at a dollar in, dollar out plus interest. Additionally, participants earn a crediting rate, similar to an interest rate, which is an annual effective yield based on the characteristics and performance of the underlying assets. The underlying assets of a synthetic wrap generally consist of intermediate-term, investment-grade fixed income instruments. A third-party investment manager generally manages the assets.

Traditional GIC

A traditional GIC is an investment contract backed by the assets in an insurance company’s general account. The term “guaranteed” in the contract’s name refers to its direct credit exposure to the issuing insurance company; the only guaranty is the credit quality of the insurance company. They typically carry a fixed interest rate and are maintained at book value for the life of the contract. This type of investment became less common in typical stable value funds after synthetic wrap contracts were introduced to the marketplace in the late 1990s.

Typical stable value fund structure: Total return focused

Most “pooled” stable value funds run by asset managers have a portfolio structure consisting of a cash position of between 3%-5%, with the balance of the fund— 95% or more — invested in wrapped bond portfolios, commonly referred to as synthetic strategies. Very few managers have meaningful or even any allocation to traditional GICs or other liquidity generating instruments maturing at par. This structure favors a bias towards total return over liquidity. While this structure may be adequate in normal market conditions, this common structure may lead to increased volatility in market-to-book ratio and crediting rate when participants and/or plans are moving assets out of stable value. The graphic below illustrates the average allocation to different stable value investment types.

A differentiated structure: Liquidity at the forefront

To deliver best-in-class results, we believe stable value managers must move beyond the traditional fund structure. In our view, combining multiple independent, but complimentary, strategies into a single stable value fund can potentially enhance portfolio returns while lowering overall liquidity risk. This includes investing across cash alternatives, traditional GICs, and wrapped, actively managed strategies.

Liquidity generation is at the forefront of this differentiated structure, ensuring that the fund consistently has adequate cash flow to handle both participant and plan-level redemptions. Due to the challenges in projecting cash flows, particularly participant driven cash flows, we believe it is prudent to build ongoing liquidity permanently into a stable value fund structure.

Aside from cash (Tier 1), additional elements are used to create liquidity as an enduring part of the portfolio structure. Unlike the typical stable value fund, our approach uses traditional GICs (Tier 2) in a meaningful way by building a bond ladder with maturities at par value. Additionally, synthetic strategies can be designed to provide scheduled liquidity at book value, as is done in Tier 3 of the structure above. The result is three layers of liquidity (Tiers 1-3) versus a single cash buffer that typical stable value funds offer. Overall, we believe purposeful, embedded liquidity helps improve crediting rate and market-to-book stability, and offers additional opportunities to increase returns over time. Furthermore, creating an ongoing liquidity structure with scheduled maturities at par helps prevent the manager from having to sell assets from their wrapped strategies to accommodate potential outflows. This concept is referred to as “withdrawal risk.”

A keystone piece: Traditional GICs

An often-overlooked investment option for Stable Value funds are traditional GICs. We believe there are four main advantages to the use of laddered traditional GICs:

1. GICs are highly customizable in terms of amount, maturity, and principal and interest payment dates. We believe this is beneficial for a fund that strives for constant liquidity generation.
2. GICs are carried at par value throughout the life of the contract. Therefore, their value does not fluctuate with movements in interest rates. This helps stabilize the fund’s overall crediting rate and market-to-book ratio.
3. GICs sit at the top of an insurance company’s capital structure and are equal in seniority with life insurance payments. If an insurance company defaults, GIC holders and life insurance payments are paid out first. This means traditional GICs are more secure than other marketable bonds of the same quality that are lower in the issuer’s capital structure, e.g., a typical unsecured corporate bond.
4. Traditional GICs may offer better relative value than other marketable bonds in certain market environments.
    

Withdrawal risk and future returns: Comparing the outcomes for different fund structures

Withdrawal risk is the probability that a manager’s cash buffer is not sufficient to handle outflows from the fund. This leads to the manager needing to sell securities from their synthetic GICs to fund liquidity events such as participant or plan redemptions. Evaluating this probability in a stable value strategy is important because these “forced sales” impact future changes in the crediting rate and may increase its volatility. Clearly, withdrawal risk is more detrimental during periods of rising interest rates or widening credit spreads—an environment that was prevalent from 2022-2024. If bonds are sold from wrapped strategies to fund withdrawals at a discount, that loss is realized and embedded in the market-to-book ratio of that strategy—ultimately impacting the portfolio’s crediting rate.

As noted earlier, the average stable value fund is predominantly comprised of synthetic strategies. As a result, many managers with the “typical” fund structure are forced to trade inside their synthetic strategies for liquidity, which increases market-to-book volatility and can negatively impact returns, especially during periods after rates have risen.

We believe a well-structured fund can provide a significant amount of additional protection for the synthetic strategies compared with the average stable value fund, making the risk of withdrawal from synthetic wraps significantly less. Over time, this can result in more consistent and less volatile returns than the industry average.

To see the difference fund structure can make, let’s consider a hypothetical scenario in which two stable value portfolios begin with the same yield (4%), duration (three years), and market-to-book ratio (100%). Then the following scenarios occur:

• Interest rates rise by 25bps for five consecutive quarters.
• Each portfolio’s yield rises by the same amount while duration stays constant at three years.
• Both portfolios have redemptions that represent 3% of total assets under management each quarter.
• The Liquidity Aware Portfolio handles the withdrawals through its liquidity structure and without selling bonds from its wrapped strategies.
• The Return Focused Portfolio is forced to sell bonds from its wrapped strategies to fund the withdrawals.

At the end of the five quarters, the crediting rate on Portfolio A is 0.56% higher than Portfolio B. This example isolates the impact of withdrawals and the resulting crediting rate effect of not having a liquidity structure.

Emphasis on liquidity creates flexibility to seek higher yields

As a result of a greater focus on liquidity, fund managers are able to offer additional flexibility from both an operational and investment perspective. As an example, managers that emphasize liquidity may be able to negotiate more flexibility within their synthetic investment guidelines due to the additional protection their structure provides to wrap issuers. This change allows managers to buy higher-yielding investment-grade securities, helping to enhance overall portfolio returns. As a result, the underlying synthetic yields—which feed into the crediting rate and returns to participants—can be meaningfully higher than the underlying yields of average managers who follow the traditional playbook. Furthermore, a focus on liquidity may allow managers to operate plan level termination provisions (such as of the 12-month “put”) with more flexibility, therefore providing plan sponsors with a better experience if a change needs to be made.

To implement the differentiated fund structure described here, managers must draw on a unique mosaic of skills and expertise, which can serve as a barrier to entry or an opportunity for alpha generation. Establishing a GIC ladder, for example, typically takes several months, due to the relationship-driven nature of the traditional GIC marketplace and the extensive due diligence involved. Credit quality is paramount, as guarantees on traditional GICs and synthetic wraps are only as strong as the financial health of the issuing institution and the underlying assets. Managers must carefully assess each issuer, often necessitating the knowledge of dedicated corporate credit analysts. This effort is multiplied when managers seek to reduce risk by diversifying among numerous issuers. Overall, effectively managing these investments requires a coordinated effort across investment, legal, and compliance teams to negotiate terms that reflect investment guidelines, underwriting, competing options, and fees.