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.