Impact of Rising Rates on Stable Value

Stable value weathered the 2020 coronavirus pandemic remarkably well. Market-to-book ratios and wrap capacity held up during the COVID crisis and performed as expected. Since the 2008 global financial crisis (GFC), the stable value industry has undergone significant reforms with improved risk disciplines from all the industry practitioners, which have contributed to the resilience of this asset class.

In 2021, stable value once again came into focus primarily as a viable alternative to money market funds as the Federal Reserve (Fed) was forced to implement a near zero interest rate policy for the second time in a little more than 10 years. In many instances, it was stable value’s strong performance at the height of the COVID crisis and increased product flexibility that convinced plan sponsors to take a second look at and revisit stable value after some left the asset class during the GFC. So how might stable value perform during the current inflation-driven rate hike cycle?

Wrap Capacity Remains Robust for the Stable Value Industry

Among the stable value industry practitioners, the wrap providers play a vital role in the overall health of the stable value asset class. Since the GFC, the wrap providers have enhanced their risk management through appropriate investment guidelines and asset surveillance. Today, bank and insurance company wrap providers are financially strong with ample wrap capacity, which should fuel not only continued growth in the asset class, but also lower wrap fees.

In 2020, the stable value industry saw record year-over-year growth in the total amount of assets wrapped. In 2021, total cash flows into stable value slowed while assets became more diversified among the universe of wrap providers.

In 2021, we also saw insurance company Great-West offer its first wrap contract that did not require utilizing its affiliated fixed income manager for the underlying assets, bringing the total number of active wrap providers in the industry to 17, according to Valerian Capital.

We are hopeful that Great-West’s entry into the wrap industry with additional flexibility will pave the way for new market entrants.

Rising Rates Present Both Challenges and Opportunities for Stable Value

Today, stable value faces many headwinds in the form of rising rates and higher inflation that the asset class has not seen in over 40 years. In addition, we are coming off historically low interest rates, where meaningfully higher rates could have a significant impact to stable value cash flows and market-to-book value ratios. However, it is important to remember that rising rates also means eventually higher crediting rates for stable value products. For older retirement investors looking for capital preservation, stable value may offer shelter from market volatility while potentially providing an attractive income.

In the first half of 2022, shorter-term Treasury yields rose sharply as the market reacted to elevated inflation, supply and demand imbalances, and a hawkish Fed focused on combating surging inflation.

As expected, higher rates negatively impacted the market-to-book value ratios across the industry as the value of the underlying fixed income assets declined. In general, the average market-to-book value ratios fell from around 101% at the end of 2021 to around 95% at the end of June 2022 (Fig. 1). While the drop in market-to-book value ratios has been abrupt, we believe that the industry is on more solid footing than during the GFC given a healthier industry today and a different market environment.

Where May Market-to-Book Value Ratios and Crediting Rates Go From Here?

Given the recent move in yields, we forecast rates along the yield curve over the next six months and modeled the impact to a hypothetical stable value portfolio. In our base-case rate scenario, we would expect that as the underlying portfolios reinvest in higher-yielding assets, the crediting rates of contracts would increase gradually over time. Under that scenario, we would also expect that market-to-book ratios in the industry would begin to rise as well.

Lastly, our base-case interest rate and yield curve scenarios do not take into consideration the impacts from participant cash flows. It has been our experience that participants have sought the safety of stable value during periods of extended market volatility. Positive cash flows into stable value would further help improve market-to-book ratios and provide managers with dry powder to invest at attractive yields.

Historical Yield Premium Over Money Markets

Historically, stable value offered a yield premium over money market funds even in periods where the Fed was hiking rates and the yield curve flattened. In the past, even during rising rate environments, stable value outyielded money market funds. Figure 2 represents the one-year rolling monthly excess returns of the Morningstar CIT Stable Value Index over the Lipper Money Market Index, and stable value has outperformed money markets in 100% of monthly periods rolling annually over the past 20 years. While the current environment is different from the previous cycles, and history may not repeat itself, it often rhymes. In the current environment, money market funds may outyield stable value for the shorter term. However, like past cycles, such inversion could prove to be temporary. With the advantages of the stable value asset class, we believe stable value should outperform money markets funds over longer periods.

As highlighted previously, we believe the stable value industry continues to be on firm footing and is coming off another strong year of positive cash flows and expanding wrap capacity. Stable value faces a challenging road ahead with rising rates and higher inflation, but participants could benefit from higher crediting rates and improved participant income because of the current rate environment. While traditional thinking may lead away from considering stable value as the Fed is committed to tightening monetary policy, we believe that plan sponsors and investment professionals should continue to evaluate stable value product offerings for their potentially attractive long-term risk/return attributes and consider adding stable value to their plan lineups as appropriate.

Past Rising Rate Environments Display Stable Value’s Potential

Many investors are apprehensive about the effect of rising rates on a stable value portfolio. But how has stable value performed in prior rising rate environments? As highlighted in Figure 3, stable value performed well relative to money market funds and comparable low-duration fixed income during prior rate hike cycles under a variety of yield curve scenarios. The top charts display the shape of the Treasury yield curve during recent Fed tightening periods, and the corresponding lower charts show stable value’s annualized returns relative to a similar asset class during those respective tightening cycles.

Conclusion

Stable value remains an attractive capital preservation investment option during periods of rising interest rates. Stable value has continued to be on firm footing and is coming off a strong year of positive cash flows and increased wrap capacity.

Despite that stable value market-to-book ratios face many headwinds in the form of rising rates and higher inflation, we believe that access to higher crediting rates and potentially improved participant income could make stable value an attractive liquidity option for retirement investors through all interest rate environments.

Compared with money market funds, stable value has performed well on a relative basis and historically has performed well during rising rate environments. Lastly, we believe plan sponsors and investment professionals should continue to evaluate stable value product offerings on attractive long-term risk/return attributes and consider adding stable value to their plan lineups as appropriate.