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Unpacking Stable-Value Funds

Higher yields than cash, with low volatility and principal protection.

Question: What are stable-value funds? Are they like money market funds with higher yields?

Answer: Stable-value funds, whose availability is limited to defined-contribution plans, such as 401(k)s, 403(b)s, 457s, and also some 529 college-savings plans, aim to deliver income comparable to that of short- to intermediate-term bonds, with volatility over the long term similar to that of money market funds and other cash instruments. Although yields have declined in recent years, stable-value funds' yields have exceeded those of money market funds by about 2% annualized since 1990, according to data from the Stable Value Investment Association, a nonprofit group that represents the industry. But higher returns usually equate with higher risk, right? You may be wondering, "Where's the catch?"

The answer is that stable-value funds are not risk-free, but they are a low-risk investments. Although they share many characteristics with money market funds--both seek to maintain stable $1 NAVs and offer downside protection--some financial advisors and industry professionals don't really consider them cash alternatives, but rather, more akin to a shorter-term bond investment. The underlying portfolios of stable-value funds are invested in mostly high-quality bonds with short- to intermediate-term maturities, which is how they are able to provide higher yields than cash alternatives. But they also purchase insurance contracts that aim to provide price stability on a day-to-day basis. Because stable-value funds' insurance contracts usually prevent any fluctuations in the funds' prices, these funds are effectively insulated from price fluctuations in the bonds they own.

According to the SVIA, there's more than $700 billion in assets invested in stable-value funds, and they are offered in approximately half of all 401(k) plans. If you have access to a stable-value option in your defined-contribution plan, it can be a good choice if you're aiming to preserve capital but earn yields that will probably edge out inflation.

What's in Them, and How Do They Work? Stable-value funds' underlying portfolios are usually a diversified mix of high-quality fixed-income investments, such as U.S. Treasuries and government-agency debt, short- to intermediate-term corporate bonds, asset-backed securities, and mortgage-backed debt securities offered through commingled bond trusts and mutual funds.

Key to the process is something called an investment contract, which is issued by an insurance company or a bank. These contracts allow the fund to calculate the assets using book value (the value of its principal plus interest) rather than "marking-to-market" or using the more-volatile market value of its holdings.

There are some different ways stable-value funds can be structured, depending on who takes ownership of the fund assets (the defined-contribution plan provider or the provider of the principal protection contract), and whether the accounts are managed separately or are commingled. But one thing all of the different types of contracts offer is a guaranteed rate of return, sometimes known as a crediting rate, which is reset periodically. "The crediting rate smooths out market volatility. If you buy a bond every day, the price can go up and down; but the crediting rate takes those movements and smooths them out over time," explains Tony Luna, co-portfolio manager for T. Rowe Price Stable Value Fund.

As you can imagine, this insurance protection has a price. The costs of the insurance wrappers went up following the financial crisis of 2008 (a period during which the market values of stable-value portfolios were well below book values and some insurers exited the market). From precrisis levels of lower than 10 basis points, postcrisis levels reached as high as 25 basis points. "Currently, we're in a trend where 25 used to be the spot, but we're starting to see pressure getting closer to 20 basis points. ... Probably around 20 basis points is what we see in the long term," said Luna.

These costs are passed along to the end investor in the form of the fund's fees, which in turn leads to lower yields on the product. Also, since the financial crisis, many insurers have enforced tighter restrictions on the underlying bonds, including higher credit-quality standards and shorter durations--both of which could also affect the funds' yields. In addition, stable-value funds, like all other bond investments, have been affected by declining yields across the board since the financial crisis.

Today, stable-value funds are yielding more than cash, but returns aren't mouth-watering; according to data in Morningstar Direct, the typical fund in the stable-value category yielded around 2% in 2013 and 2014, and it has yielded about 1% for the year to date. That still beats the Morningstar Taxable Money Market Index, which has yielded close to zero during the same time periods.

What Are the Risks? A portfolio of high-quality bonds wrapped up by an insurance-contract guarantee sounds like a pretty low-risk investment--and, in fact, it is. But because stable-value funds' underlying portfolios are largely composed of bonds, these funds are subject to some of the same risks facing fixed-income investments. Among these risks are credit risk, default risk, and liquidity risk. Stable-value funds' insurance protection certainly mitigates these risks but doesn't entirely eliminate them.

The insurance wrappers help insulate against price changes when yields trend up, and in a rising-rate environment, as some bonds in the portfolio mature, the fund manager can reinvest those assets in higher-yielding assets. However, it's worth noting that stable-value crediting rates (though they trend toward market rates) typically do not react as quickly to rate changes as money market yields.

The risk of default within the underlying portfolio, though not nonexistent, is also pretty low, given the high quality of the underlying bonds, the fact that stable-value funds diversify across issuers, and the heightened quality standards put in place by the insurance-contract providers post-financial crisis. If securities in the fund's portfolio do experience a default or downgrade, however, the contract's principal-protection guarantees may not apply.

Another risk that stable-value funds may face is the risk that cash flows into and out of the fund can be uneven, which could affect the portfolio's market value/book value ratio and, therefore, its crediting rate. One safeguard against this, however, is the fact that holding bonds with different maturity dates means that some bonds in the portfolio are maturing at book value to help meet liquidity needs. Moreover, stable-value products are offered via defined-contribution plans, whose participants generally make regular contributions and have an intermediate- or long-term investment horizon. In addition, many stable-value products include contractual limitations on large-scale withdrawals that are driven by plan-sponsor actions, such as a 12-month waiting period. Also, to prevent arbitrage or yield-chasing, stable-value funds typically have an equity wash rule, which means that an investor looking to transfer funds to a competing investment, such as a money market fund or short-term bond fund (generally a fund with a duration of less than 3.5 years), must first invest that money in a stock fund (or another type of fund not considered a competing investment) for at least 90 days.

Could I Ever Lose My Principal? Many investors in stable-value funds are primarily concerned with the preservation of capital. The protections afforded by these contracts mean that, in most cases, if the fund's underlying portfolio loses value, the bank or insurance company will step in to cover the shortfall. But it's worth pointing out that there are some risks, however rare, that are not covered in the stable-value fund's principal-protection contracts, which is why they can't truly be considered as safe as cash. Among these risks are layoffs, mergers, and bankruptcy.

Here, bankruptcy refers to either the bankruptcy of the employer or plan provider, or of the insurer offering the stable-value protection. In the event that an employer goes bankrupt, the plan sponsor and the protection provider generally have time to figure out a plan to cover the assets in the stable-value fund so that the participants can continue to transact at book value, according to the SVIA. But this did not happen in the case of Lehman Brothers in 2008, due to the scale of the bankruptcy (the largest in U.S. history) and the swiftness at which it proceeded. Lehman's bankruptcy led to huge withdrawals from the stable-value fund in Lehman Brothers' retirement plan, forcing the plan sponsor to have to sell underlying securities at a discount. The stable-value fund in Lehman Brothers' plan had a return of negative 1.7% in December 2008 but still managed an annual return for 2008 of 2%, according to the SVIA.

A stable-value fund may also be impacted if the insurer or other provider of the principal protection becomes insolvent--essentially, you're placing your trust in the full faith and credit of the provider of that principal protection. It should be noted, too, that stable-value funds often contract with multiple insurers to reduce this sort of company-specific risk.

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The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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