During periods of market turbulence and low interest rates, many investors struggle to find investment alternatives that aren't getting hammered. But those saving for retirement may be pleasantly surprised to discover a unique breed of mutual fund known as stable value funds. These funds are somewhat similar to money market accounts, except that they post much higher yields with relatively little risk. We'll explore stable value funds and their advantages and disadvantages, as well as for whom these funds are appropriate.
What Is a Stable Value Fund?
As their name implies, stable value funds are a type of cash fund that resembles money market funds by offering protection of principal while paying stable rates of interest. Like their money market cousins, these funds maintain a constant share price of $1. However, stable value funds have typically paid twice the interest rate of money market funds. Even intermediate term bond funds tend to yield less with considerably more volatility.
Stable value funds used to invest almost exclusively in Guaranteed Investment Contracts (GICs), which are agreements between insurance carriers and 401(k) plan providers that promise a certain rate of return. However, a number of insurance carriers that invested heavily in junk bonds in the '80s suffered heavy losses and defaulted on some of their agreements. Retirement plan participants of other providers, such as Lehman Brothers, which declared bankruptcy, discovered that their GICs became invalid in the event of corporate insolvency. Therefore GICs fell largely out of favor as funding vehicles for stable value funds.
These funds now invest primarily in government and corporate bonds with short- to medium-term maturities, ranging from approximately two to four years. Stable value funds are therefore able to pay higher interest than money market funds, which usually invest in instruments with maturities of 90 days or less. Of course, this means that the holdings within stable value funds are also more susceptible to changes in interest rates than money market holdings. This risk is mitigated by the purchase of insurance guarantees by the fund that offset any loss of principal, which are available from around a dozen different banks and insurance carriers. Most stable value funds will purchase these contracts from three to five carriers to reduce their default risk. Usually these carriers will agree to cover any contracts defaulted upon in the event that one of the carriers becomes insolvent. There has also been a recent shift towards more conservative portfolio offerings as a result of the market meltdown in 2008. (For more, see The Money Market: A Look Back.)
Pros and Cons
As mentioned previously, stable value funds pay an interest rate that is a few percentage points above money market funds. They also do so with substantially less volatility than bond funds. However, these funds also charge annual fees that cover the cost of the insurance wrappers, which can be as high as 1% per year in some cases. Furthermore, most stable value funds prevent investors from moving their money directly into a similar investment, such as a money market or bond fund. Participants must instead move their funds into another vehicle such as a stock or sector fund for 90 days before they can reallocate them to a cash alternative.
Perhaps the biggest limitation of stable value funds is their limited availability: They are generally only available to 401(k) plan participants of employers who offer these funds within their plans.
Another key point to remember is that these funds are stable in nature, but not guaranteed. Although the chances of losing money in one of the funds is relatively slim, they should not be categorized with CDs, fixed annuities or other instruments that come with an absolute guarantee of principal. (To learn more, see our Traditional IRA Tutorial.)
Who Should Invest in a Stable Value Fund?
Stable value funds are excellent instruments for conservative investors and those with relatively short time horizons, such as workers nearing retirement. These funds will provide superior income with minimal risk and can serve to stabilize the rest of the investor's portfolio to some extent. However, they should not be viewed as long-term growth vehicles, and they will not provide the same level of return as stock funds over time. Most advisers recommend allocating no more than 15-20% of one's assets into these funds. (For more tips, read Asset Allocation Strategies.)
Stable value funds serve as a happy medium between low-yielding cash and money market funds and bond funds, with their higher risk and volatility. These funds provide higher rates of interest with little or no fluctuation in price. However, this stability comes at a price in the form of annual fees, and transfers into other cash instruments can only be made under certain conditions. To learn more about stable value funds, visit www.morningstar.com or consult your financial adviser. (For more, see our Investopedia Special Feature: Individual Retirement Accounts.)