NEW YORK (TheStreet) -- With the Federal Reserve holding down interest rates, plenty of cautious savers feel forced to accept puny yields. Money-market funds pay next to nothing, and most five-year certificates of deposit yield less than 1%. But investors in 401(k) plans have a richer alternative: stable value funds, which yield 2.9%.In recent years, stable value funds have served as workhorse investments, accounting for 12% to 15% of assets in 401(k) and other defined contribution retirement plans. The funds have $540 billion in assets, according to the Stable Value Investment Association. The value of the stable funds became clear as the financial crisis savaged 401(k) plans. During 2008, stocks plummeted, and many bond funds dropped sharply. But throughout the turmoil, millions of savers were protected by holding stable value funds. Nearly all the funds stayed afloat, returning more than 4% for the year. 8 Stocks Rising Fast on Rich People's Spending Some investors think of stable value funds as bank accounts. The funds protect principal and pay interest. But the stable value accounts are not guaranteed by the Federal Deposit Insurance Corp. Instead the returns of the funds are protected by insurance contracts known as wraps that are offered by banks and insurance companies. In some key respects stable value funds resemble intermediate-term bond mutual funds. Both kinds of funds invest in portfolios of bonds. When interest rates rise, the value of the bonds tends to fall. If that happens, a shareholder in a typical bond mutual fund could lose principal. In contrast, a saver who makes a withdrawal from a stable value fund would not suffer because the insurance contract protects against principal losses.
For protection, stable value portfolio managers tread cautiously, putting nearly all their assets in bonds that carry the highest credit ratings of AAA and AA. In contrast, many intermediate mutual funds hold bonds of varying credit qualities, including issues that are rated BBB, the lowest investment-grade category. 3 Mutual Funds for an Improving Economy Stable value funds also limit risk by holding a mix of maturities, including intermediate-term bonds as well as short-term bonds. When interest rates rise, bonds tend to fall. But the stable value portfolios suffer only limited swings because short-term bonds tend to be resilient. Intermediate funds have longer average maturities, which makes the portfolios riskier. Should you favor a stable-value fund over an intermediate-term mutual fund? Conservative investors may prefer stable value. But those who can tolerate some risk could choose intermediate funds -- or perhaps hold a mix of stable value and intermediate funds. Because they hold longer maturities with lower-quality issues, intermediate funds tend to yield about a half-percentage-point more than stable value funds. The extra yield should enable the intermediate funds to outperform stable value over the long term. Most young investors should only hold a small allocation to stable value funds, cautions Winfield Evens, director of investment strategy for consultant Aon Hewitt's defined contribution unit. "It may make sense to keep a fraction of your money in a stable value fund and away from market risk," says Evens. "But over 20 or 30 years, stable value investments may not keep pace with inflation." 10 Stocks Owned by the Best Fund Managers Evens says that during the financial crisis, some 401(k) investors dumped stock holdings and shifted to stable value funds. Such investors missed the big gains that occurred when stocks rallied up off the market bottom. For better results, most investors should diversify broadly, holding portfolios that include stocks and bonds as well as safe choices like stable value funds.