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Goldman Sachs’ Swell Highlights Risks, Opportunities for Stable Value Managers

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Some risks are obvious, others not so much.

The Federal Reserve is expected to start raising short-term interest rates later this year, and everybody recognizes that rising rates present some risk for stable value portfolios, in part because they can reduce the value of the fixed-income securities held in the typical stable value investment portfolio. But what about agency mortgage-backed securities? They’re among the risks stable value managers are facing this year, too, according to Michael Swell, managing director and co-head of Global Portfolio Management for the Global Fixed Income team at Goldman Sachs Asset Management.

The risk associated with agency mortgages may not be as obvious as interest-rate risk, but it is real, Swell said during an address to the 2015 SVIA Spring Seminar in mid-April. He explained that the issue isn’t default risk but rather the “significant embedded optionality that in a rising rate environment could cause a stable value portfolio, a short-duration portfolio, to extend meaningfully in duration.” Swell said that if rising rates resulted in a significant slowdown in prepayments of agency mortgages, 30-year mortgage pass-throughs could go from having a three- or four-year average life to seven or maybe even 10 years. As a result, stable value managers could experience greater-than-anticipated market losses in their investment portfolios.

Swell also commented that other sectors of the fixed-income markets look more appealing. He said that Goldman Sachs Asset Management remains constructive on commercial mortgage-backed securities, in both agency and private-label sectors. Collateralized loan obligations represent an attractive return-per-unit-of-risk for bank buyers, he added, and FFELP Student Loan asset-backed securities present attractive spreads for a high-quality security. Swell remarked that in general the economic environment is favorable for credit right now, with investment-grade credit offering wider-than average spreads over Treasuries of about 125 basis points. “We think credit has the potential to get expensive,” he said, “but it’s not right now.”

Turning to the broader investing climate, Swell said that overall global economic growth has improved, with the U.S. continuing to grow at a moderate pace and Europe reviving, although growth in China has slowed and Greece’s debt woes are back on the front page. Both of the latter factors are threats to global economic stability.

Swell said the apparent slowdown in U.S. economic growth in the first quarter may have been driven by severe winter weather and will likely prove temporary. “We will probably see something like 1 percent growth in the first quarter, but we expect it to pick up meaningfully in the second and third quarters,” he said.

Although inflation remains subdued in the U.S., thanks in part to low oil prices, Swell said there is evidence that wage pressures are building, which could help convince the Fed to begin raising interest rates later this year. He said current low oil prices are a net positive for the U.S. economy over the long term. While difficult for energy companies and those that cater to them, low oil prices allow consumers to spend less on fueling their cars and heating their homes and more on other goods and services. “We expect to see retail sales pick up as a result of the effective tax cut consumers have received in the form of lower oil prices,” Swell said.

Swell said that even though the Fed appears to be on track to start raising short-term interest rates in 2015, it will probably wait until September to do so, thanks to, among other things, the strong U.S. dollar, slowing momentum in the U.S. economy, soft economic conditions in a number of other countries, and modest levels of inflation in just about all developed economies. He said that against that backdrop the Fed isn’t likely to be overly aggressive when it does start to push interest rates higher. Moderate rate increases aren’t as troublesome for the stable value industry as sharp rate increases, and over time can lead to higher crediting rates for stable value investors.