The bonds held in stable value funds can’t be valued at book value, because accounting rules require that they be held at market. The stable value pool goes out and purchases derivatives known as wrap agreements in order to allow the bonds to be held at book value. The wrap agreements agree to pay or receive money if any of the bonds have to be liquidated at a loss or gain respectively, thus making the fund whole for any book-value loss.
Typically, wrap agreements are only done on the highest-rated bonds, AAA, so credit risk is not covered by most wrap agreements. With most wrap agreements, once a payment is received or made by the wrapper, the wrapper enters into a countervailing transaction with the pool to pay or receive, respectively, a stream of payments over the life of the bond that was wrapped equal to the present value of the initial payment when the bond was tapped. The wrapper bears almost no risk in the arrangement; the risks are rated back to the stable value pool, and the stable value pool pays for the gains and losses through an adjustment to the pool’s credited rate. Because wrappers bear almost no risk, wrap pricing in 401(k)-type plans is typically 0.05%-0.10% per year of assets wrapped. The only risk a wrapper faces is that the interest-rate-related losses on a bond in a rising interest rate scenario are so severe that the losses can’t be repaid out of the yield of the wrapped bond. In this case, the wrapper would have to pay without reimbursement.
Interest Rate Risks
Stable value funds attempt to maintain a stable share price, but the assets underlying the fund vary as interest rates, prepayment behavior and credit spreads change. There is almost always a difference between the book value of the assets, expressed by the NAV, and the market value. When the stable value fund has a higher market value than book value, typically it pays an above-market yield. There is a risk that in an environment where interest rates have risen sharply, a stable value fund would have a lower market value than book value, with a below-market yield. In a situation like this, particularly when the yield curve inverts, there is a risk that shareholders in the stable value fund will leave in search of higher yields.
