After several premature obituaries over the past dozen years, many pundits are calling for the end of the three decade long bull market for bonds. Since July, when the benchmark 10-year US Treasury note hit an all-time low yield of 1.36%, bond yields have ratcheted higher. This trend accelerated with the election of Donald Trump as president, which was not priced into the capital markets. Post-election, as investors have focused on potentially favorable regulatory and tax policy changes, stronger economic growth and higher inflation, US Treasury yields have climbed another 50+ basis points. As of November 30th, 5 and 10 year US Treasuries were yielding 1.90% and 2.38%, respectively, up roughly 100 basis points from their summer lows.
Plan sponsors and consultants have asked the very reasonable question, how will my stable value fund perform in an environment of rapidly rising rates? While not our base forecast, this paper explores how stable value funds fared in prior episodes of rising interest rates, and offers some observations and general comments on the current environment.
Since the mid-1980s, the secular decline in bond yields has been briefly interrupted by several Federal Reserve tightening cycles that resulted in painful bear markets for bond investors. Stable value funds performed as designed in these environments, shielding participants from declining bond prices and allowing participants to earn a steady, stable return on their retirement savings.
In general, crediting rates (e.g., returns) on stable value funds lag changes in market interest rates. This is by design. All stable value funds employ “book value” wrap contracts – a type of insurance – that smooth the price volatility of an underlying bond portfolio. Plan participants are thus protected against sharply rising rates, in that they can transfer money out of the fund at book value (cost plus credited interest) and not suffer a principal loss associated with a market valued, unwrapped bond portfolio. Book value wrap contracts use a fairly standard formula for crediting returns to participants (see sidebar). This formula takes into consideration the yield-to-maturity, duration and total returns of the underlying portfolio. In effect, it amortizes bond price changes into the crediting rate, smoothing the impact on investors.
To illustrate how stable value funds work, we have constructed a hypothetical portfolio using the Bloomberg Barclays 1-5 Year Government/Credit Index as the underlying fixed income portfolio. The index has a duration in line with most stable value portfolios – currently 2.75 years – and captures returns of investment grade corporate bonds, US Treasuries and Agencies. The portfolio was created in September 1991, with monthly book value returns calculated using the standard crediting rate formula and characteristics of the index (yield-to-maturity, duration and monthly total return).* This allows us to examine crediting rates and market-to-book value ratios (described on page 2) during periods of interest rate volatility, and is a very good proxy for how most stable value funds have fared over time. Using index data also isolates the effect of interest rate changes on the portfolio, which can often be obscured by participant cash flows and/or investment manager actions.
Looking back over the past 25 years of bond market history, three key periods of rising rates stand out.