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Do Interest Rates Affect Stable Value Funds?

    Stable Value Funds Invest in a Variety of Fixed Income Securities

    • While they function in a manner that is similar, stable value funds are not money market funds. They invest in a variety of fixed income instruments, including U.S. Treasury securities, government agency bonds, corporate bonds, mortgage-backed securities, commercial mortgage-backed securities and asset-backed securities. In addition to derivative securities, stable value funds also invest in contracts issued by insurance companies and other financial institutions. Known as wraps, these insurance contracts permit the stable value funds to use book value accounting to maintain a constant $1 net asset value.

    The Type and Duraton of a Stable Value Fund's Securities Determines Its Returns

    • The most important determinant of a stable value fund's return is the portfolio of securities in which it is invested in terms of type of securities, diversification, the duration or maturity of the securities and their credit quality. Returns are also affected by other factors such as the volume and frequency of fund purchases and redemptions, which in turn contributes to portfolio turnover. Typically, stable value funds invest in securities with an average weighted credit quality of AA or higher while maintaining a duration of two to three years. If anything, stable value portfolios' credit quality and diversification have improved following the financial crisis and the imposition of stricter guidelines on the part of insurance company wrap providers.

    Rising and Falling Interest Rates Have a Corresponding Effect on Stable Value Fund Returns

    • This being the case, rising and falling interest rates will have a corresponding effect on the returns achieved by stable value funds. This means that, as interest rates rise, the returns achieved by stable value funds will also increase, even though, initially, the returns might lag. Conversely, as interest rates decline, the returns achieved by stable value funds will also decline.

    Illustration Using Three-Year Treasury Securities

    • Here is an example of this, using the three-year constant maturity Treasury securities as a benchmark. The yields on three-year Treasuries reached a month-end peak of about 5 percent a year or so prior to the onset of the financial crisis as of June 2006 and these have been declining since, reaching over 1 percent by the end of 2009 or a decline of about 4 percent. During that same interval, the average return of stable value funds declined from 3.7 percent to 2.5 percent, or a 1.2 percent decline. Conversely, in 1990 when yields on three-year Treasuries hovered between a high of almost 9 percent and 7 percent, average stable value fund returns were about 7 percent.

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