If you have a 401(k) or other tax-sheltered retirement plan, one of the investment options may be a stable value (SV) fund. In today’s low interest rate environment, stable value funds have been popular as they offer the stable price of a money market fund but with a higher yield. This is due to the fact that they are basically intermediate-term bond funds wrapped in an insurance contract that guarantees it maintains a “stable value”. This means the book value that you see can differ from the actual market value.
In my case, I invest some money in them because they offer a 3% yield on previous contributions (current contributions earn 1.25% on which I passed). Compare that with a money market fund earning 0.01%, or the Vanguard Intermediate Bond fund with a 6.4 year duration and only a 1.78% yield.
However, if interest rates were to rise quickly, this would lower the market value of those bonds (as interest rates go up, bond values go down) at the same time that there may be a rush of redemptions. Would the fund be able to cash people out at the higher book value as promised? A recent Vanguard research paper ran some scenarios based on historical periods of rising interest rates (1986-1990 and 2004-2008). They used Vanguard’s pooled fund, the Vanguard Retirement Savings Trust, with an average duration of underlying investments of ~2.6 years. Read the paper for details, but the overall conclusion was that the stable value funds would survive such scenarios:
Although stable value funds in general have performed well through past market cycles and crises, in the current environment of low interest rates both stable value investors and contract providers have been concerned about the effect rising interest rates would have on the funds and the ability of the funds to continue to perform well when further stressed by cash outflows.
[…] …in our simulations, the funds’ MV/BV ratios demonstrated resiliency, and crediting rates fluctuated within a band far narrower than that of market yields, even in extraordinary scenarios.
While the paper’s findings provide some reassurance, I’m reminded that lots of people “stress tested” mortgage-backed securities in 2007 as well. Based on the Vanguard analysis, here are some additional cautionary steps to take for potential investors in stable value funds:
- Remember the basics of stable value funds. SV funds are intermediate bonds wrapped in an insurance guarantee, so if the insurance fails then you’re just left with bonds. This isn’t the end of the world, but make sure you’re okay with that. See previous post on stable value funds risks and rewards for real-life examples.
- Understand your specific withdrawal restrictions. There are usually some form of liquidity restriction attached, but they can vary greatly. In some cases, you have to give a full 12- to 24-month notice to withdraw at book value (guaranteed principal). In my plan, I am not allowed to transfer into any other fixed income (bond) funds at all. I can transfer at any time into a stock fund, but then I have to wait 90 days until I can transfer again to another bond fund. This Reuters article reports that some providers have been cutting back on guarantees.
- Be aware of scenarios where your stable value fund will be under stress. Usually, this results from rapidly rising interest rates. For example, if the yield on money market funds rise, people will prefer those to stable value funds. Also, the market value of the underlying bonds will fluctuate, even though only the book value is reported on your statements. If the market-to-book ratio on your SV fund drops below 98% (see updated prospectus), people may panic and start to withdraw.