The passion for stable value funds ebbs as SEC questions flow.
Despite the popularity that stable value funds have
enjoyed in the last few years, as part of a diversified portfolio for
individuals' retirement accounts, the unique funds have fallen by the
wayside in recent months as financial advisors search for alternative
investments for their clients.
As recently as last summer, individuals had $7 billion of savings invested in stable value mutual funds, according to Barron's Online. But that investing option has disappeared for individuals because of questions raised by the Securities and Exchange Commission about how to value the funds, although no formal ruling against them has been made.
Stable value funds are actually short-term bond funds protected by insurance contracts, known as wrappers, issued by large banks or insurance companies. The insurance contract guarantees that the owner will receive a set price for the bond, no matter what actually happens to the market price. The funds normally would be attractive in a cycle of rising interest rates, such as now, because unlike other bonds, the returns do not decline.
Stable value funds have been available for many years, and remain available today-although on a much more limited basis-in some 401(k) plans and defined benefit pension plans maintained by employers. These investments come under the jurisdiction of the U.S. Department of Labor, which has strict, but somewhat different regulations, from the SEC. The SEC's questions affect investments by individuals in IRAs, says Jim Holtzman, CFP, CPA, a financial advisor with Legend Financial Advisors Inc. in Pittsburgh.
"Stable value funds are one of the few asset classes that consistently generate positive returns and principal protection in all market cycles, which explains why retirement investors seek [them] out," according to the Stable Value Investment Association, a trade organization for the funds based in Washington.
Scudder launched the first stable value IRA fund in 1997, offering the funds as Scudder Preservation Plus Income and Scudder Preservation Plus. Others were offered by PBGH, Gartmore Morley, Oppenheimer and other mutual fund managers.
But the SEC began raising questions about how to determine the daily valuation of funds with insurance wrappers, which managers had been pricing at book value. The wrapper agreement, which is what made the stable value fund what it was, was also the part that was raising questions at the SEC. The SEC, which initially approved the funds, will not comment on the situation other than to say that there are no stable value funds now registered with the SEC, although there are some nonregistered ones in existence, says John Nester, an SEC spokesman.
The Financial Accounting Standards Board, regulators for the accounting industry, also is evaluating the funds, Nester said. In the past, the FASB has favored valuing the portfolios at book or contract value, even if they are trading slightly below market value at the time.
"When the SEC began questioning the legitimacy of stable value funds, they were no longer offered, and companies that were thinking of getting into this market decided not to," Holtzman says. "The insurance wrapper can no longer be offered so the net asset value of the funds will fluctuate. These funds were popular because the return was 1% or 2% greater than money market funds, even during periods when interest rates are rising and bond funds are falling."
"It was a way to get a piece of fixed income for the portfolio and avoid the risk of price fluctuations" and still earn more than a money market, he adds.
John Gay, a CFP licensee at Frisco Financial Planning in Frisco, Texas, notes there may still be a few stable value funds on the market, but he always shied away from them and now the SEC constraints keep most planners away. "These funds were only available for IRA or tax-deferred type accounts, and I do not like my clients to keep much in a retirement account because then the money is not accessible," Gay says. "Stable value funds would have been much more valuable if they had been available in other investing realms."
The SEC questions were enough to make those managers offering IRA stable value funds to withdraw the option. PBHG flatly said in a filing note that the "current regulatory uncertainty regarding the valuation methodology of wrapper agreements by mutual funds" had prompted the decision to stop offering stable value funds.
PBHG seemed unwilling to take the risk of having to replace the stable value funds for individual investors, in a market with rising interest rates, if that is what the SEC decided to order at some point in the future, according to Morningstar analyst Eric Jacobson, so it decided not to offer them. Others, such as Fidelity, also were ready to enter the market but changed their minds when the SEC questioned the pricing.
"Given the dearth of high-quality, high-returning options available to fixed-income investors to combat the danger of rising interest rates, this admittedly pricey asset class has been a welcome diversifier for many investors," Jacobson says.
For financial advisors who had used stable value funds to help diversify their clients' retirement portfolios, alternatives are now needed. Ultrashort-term bond funds of one to three years are part of the answer, according to Gay.
"These bond funds have a little fluctuation in the net asset value, but not much. These are the same types of bonds used for stable value funds, but without the insurance wrapper, which costs a premium," he says. "Once mature, I roll over the assets. This is a timely topic now because of the rising interest rates, but advisors should look to keep the maturity rate of any bonds short for anyone looking to bonds for diversification rather than for immediate income. Short term is the most advisable."
For both government and corporate bonds, Gay advises investors to look at nothing longer than intermediate-term bonds, with five-year maturities as an outside limit. Advisors should note the expense the bonds can carry and determine if it is worth it to the client, and read the prospectus carefully on corporate bonds to make sure junk bonds are not included among the offerings.
Legend Financial's Holtzman warns that clients invested in intermediate government bonds of five-year maturities or more can be caught in a market with rising interest rates. "You have to do an interest rate assessment because you want to diversify, but with rising interest rates, government and security bonds are going to decrease in value. If the client needs to liquidate, the value will have decreased," Holtzman says.
A different and more acceptable alternative are bank loan mutual funds, also known as prime rate funds, which are senior-secured floating-rate bank loans. They are created when banks lend money to corporations to purchase large amounts of equipment or to build new facilities. Many banks sell those loans to mutual funds or institutional investors.
"These funds are beneficial now because, in a rising interest rate environment when most fixed-income funds are dropping, bank loan funds are a mutual fund that will actually increase in value," Holtzman says. "The underlying bank loan that you are invested in has a rising interest rate, and the investor is taking advantage of that. The downside is you can run the risk the underlying loan will not be repaid.
"We work with bank loan mutual funds that are based on a secured loan, backed by assets. That is how we utilize bank loan funds, because it gives an extra comfort level," Holtzman says.
The value of bank loan funds is not completely fixed, as they can increase or decrease slightly with the rise and fall of interest rates, the opposite of most bonds. This fluctuation is caused because bank loan interest rates are reset within 60 days to 90 days after interest rates change.
"Bank loan funds have little or no correlation with any asset class and can be a good hedge against declining stock prices and inflation," says Louis Stanasolovich, CFP, founder, president and CEO of Legend Financial Advisors, in his newsletter, Risk-Controlled Investing. "However, the credit and liquidity risk on these vehicles are a consideration that should not be overlooked." He has predicted bank loan funds will be one of the best-performing investments over the next five years.
Banks do at times lend money to poor credit risks that can default on the loans, making them worthless. Most of the loans are not monitored by credit agencies because the banks do the credit analysis themselves.
"A downside to bank loan funds is that it is now a small market, so options to buy and sell are limited, making the money inaccessible at times."Bank loan funds can be considered an alternative fixed-income investment since they make money when bonds don't," Stanasolovich says, "As interest rates increase, these funds are an even more valuable part of any portfolio. We believe these investments will become significantly more popular in the next few years as interest rates rise."
Karen DeMasters is a freelance writer
based in New Jersey who is a regular contributor to The New York Times
and various business publications.