Income investors constantly search for the best yields they can find. At the same time, they have to be careful not to take on risk that will threaten their entire investment.
In comparison to the returns on stocks -- especially lately -- no short-term savings investment looks very attractive. But if you need stability in your portfolio, putting everything you own into stocks isn't the best idea. Any investor who has weathered the storm of a bear market knows that diversification into other assets, such as bonds, can help smooth losses during market downturns.
Bonds, however, come with their own risks. As many investors have seen recently, rising interest rates can wreak havoc with the value of your bonds. Those who chose not to lock up their money in longer-term bonds have avoided much of the damage, but short-term savings vehicles typically pay significantly lower yields than their longer-term counterparts.
Enter stable value
Stable value funds purport to offer investors the best of both worlds. Their yields tend to be significantly higher than those of other short-term investments, such as money market mutual funds. At the same time, however, stable value funds are designed not to fluctuate in price. This distinguishes them from bond mutual funds -- even those that own bonds with very short maturities generally can't prevent small price fluctuations when interest rates move.
Stable value funds hold a variety of fixed-income investments, including bonds and guaranteed investment contracts purchased directly from corporate issuers such as banks and insurance companies. You'll most often find stable value funds as investment options within institutional plans, such as employer-sponsored 401(k) plans or state-sponsored 529 college savings plans. In addition, some mutual funds make stable value funds available to general investors.
What's the catch?
You might think that with higher rates and little risk, people would flock to these funds. Indeed, stable value funds are popular investments within 401(k) plans -- some say too popular. As fellow Fool Amanda Kish has observed, most investors should use a more aggressive approach to their retirement investing within a 401(k) plan. Yet many participants, stung by memories of Enron employees losing their entire retirement nest eggs, continue to demand options with little or no risk of losing principal.
The reason why stable value funds aren't more popular may stem from problems in the 1980s. As junk bond financing became popular, several large insurance companies offered guaranteed investment contracts to stable value funds within retirement plans. Some of them, including Mutual Benefit Life and Executive Life, later failed, tying up participants' money in court proceedings for extended periods of time. Theoretically, investors in stable value funds could lose principal if the funds held investments that went into default.
However, just as no money market mutual fund has ever passed on losses to its investors, it would be suicide for stable value funds not to make their investors whole in the event of a financial loss. Nevertheless, history gives a valuable reminder that the guarantee of an insurance company, while having some value, isn't the same as the protection of FDIC insurance or backing by the U.S. Treasury.
Not a bad choice
Still, for most people, having at least a portion of their retirement plan savings in short-term investments isn't a bad idea. But if a stable value fund is an option within your plan, be sure to look at the fees it charges. In addition, your plan may impose certain restrictions on transferring funds between a stable value fund and other fund options in order to prevent frequent trading.
Also, try to find out what investments the fund owns. The biggest issuers of investment contracts typically held by stable value funds include New York Life, Met Life
So if your 401(k) offers a stable value fund, don't reject it out of hand as too good to be true. It may be exactly what you need to increase the income from your retirement savings.
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Fool contributor Dan Caplinger is being forced to give up his money market mutual fund in his 401(k), but he's not too worried. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy is always stable.
