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In a volatile market, retirement investors may find this type of bond fund appealing

Capital preservation is a priority for many retirement investors, especially those who are in retirement or are nearing the end of their working years.

Investors who experienced the sharp market downturn in 2008 may be particularly wary of market turbulence and may seek alternatives designed to protect their portfolios from losses. However, capital preservation cannot be guaranteed. Investors who are attracted to the stock market know that stock indexes have climbed to historic records, leaving plenty of possibilities for declines.

Investors also have reason to question the relative “stability” of bonds as they construct their portfolios, since there are known risks there, too. Bonds have had a long rally when interest rates have fallen. Most economists think rates will continue to rise as economic growth picks up, causing bond values to fall. Bonds also come in different flavors, some with more interest rate and credit risks than others. Both stable value funds and comparable-quality bond funds are generally backed by higher quality, investment-grade bonds. But what about the impact of interest rates on comparable-quality bond and stable value funds?

Stable value funds can be an investment option for risk-averse, income-oriented investors. Although the bonds that underlie stable value funds may fluctuate in value, these funds offer capital preservation in rising-rate markets, along with income, which is usually higher than money market yields. And, as rates rise gradually, so does the income that stable value funds generate.

Right now, interest rates are trending upward, after a nearly 30-year stretch of trending down. Investors need to understand that when interest rates increase, bond prices go down. As a result, investors who are focused on preserving their assets may want to look at stable value funds as an alternative to bonds for the conservative portion of their portfolios.

Stable value funds can be constructed in many different ways, but in general they preserve capital, provide relatively attractive stable returns, and allow retirement investors to withdraw assets at book value for benefit payments. The yield from a stable value fund, or crediting rate, fluctuates with changes in interest rates and credit conditions, but the likelihood that the investor will lose money from a gradual change in interest rates and credit conditions is low.

A stable value fund’s crediting rate is based on the relative value of the underlying portfolio value to that of the stable value fund spread out over the duration of the underlying portfolio plus the current yield of the underlying portfolio. When rates go up, this crediting rate goes up too, though not on a one-for-one basis. That’s because gains and losses of the underlying portfolio from credit conditions and interest rate decreases or increases, respectively, are amortized and spread out over the duration of the underlying portfolio. As a result, the yield from a stable value fund will not rise — or fall — as fast as the yields of traditional bonds of the same duration.

Longer-term, stable value funds spread the impact of interest rate changes over a more or less consistent number of years, so their crediting rates can follow interest rates yet remain relatively stable when rates change.

Because stable value funds reflect interest rate changes more slowly than traditional bonds, they may occasionally lag other investments’ yields. For instance, when rates increase very quickly, money-market fund yields may temporarily outpace the crediting rates of stable value funds. However, in most markets, and over most time periods, stable value funds have provided higher yields than money-market funds.

Because they provide capital preservation and generate relatively attractive yields, stable value funds can provide a sound, conservative core for a retirement portfolio. However, not all stable value funds are created equal. In addition to interest rate risk, liquidity and credit risks should also be considered.

When evaluating retirement plan options, investors should consider seeking stable value funds that provide:

•Broad diversification by types of stable value investments (such as traditional, separate account and synthetic GICs, and the diversification of such stable value investment issuers.)

•Diversification of fixed income sectors, industries, issuers and individual bond issues.

•Diversification across fixed income managers and investment styles, so that the underlying portfolios are managed with different styles and strategies, providing multiple diversified sources of returns.

•Skilled fixed income management, since performance of the fund will largely depend on performance of the underlying bond portfolios.

•Experienced stable value management, to structure the stable value portfolio in a manner that considers and addresses many technical nuances to managing this type of fund.

The current investment environment may be challenging for retirement investors who are focused on preserving the value of their portfolios. Stocks may be poised for a correction and assets that are often considered “safe” like bond funds can lose value when rates rise, as many expect over the coming months. In this environment, stable value funds have a role. They can offer stability, income, and capital preservation. They’re a sound choice in many environments — even when interest rates rise.

Karen Chong-Wulff is the managing vice president, fixed income, in the Investment Division of ICMA-RC. She oversees all fixed income, stable value and cash portfolios, and serves as lead portfolio manager for internally managed stable value portfolios including the VT PLUS Fund.

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