Substitutes for Stable-Value Funds

Investors in stable-value funds want it both ways. They prefer the stability of a money-market fund with the higher returns of a bond fund. By buying insurance to guard against share-price declines, stable-value funds have, with a couple of minor exceptions (see Stable Funds in Chaotic Times), been able to keep customers happy. No wonder employer-sponsored retirement plans have more assets in stable-value funds than in any other category.

Stable-value funds typically yield a couple of percentage points more than money-market funds. Currently, the average stable-value fund yields 3%, while the average taxable money fund yields 0.06% -- essentially nothing.

Unfortunately, stable-value funds aren’t available to everyone. About half of employer-sponsored retirement plans have a stable-value option, and you can find them on the investment menus of some 529 college-savings plans. Moreover, you can’t buy a stable-value fund directly from a financial-services provider.

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If you don’t have access to a stable-value fund, consider a high-quality bond fund instead. Many of them yield more than stable-value funds, which typically hold high-quality corporate bonds, rated single-A or better, that mature in two to five years. But regular bond funds can’t guarantee the constant share-price value that makes stable-value funds so attractive to risk-averse investors.

Bond funds face two main kinds of risk. First, there’s interest-rate risk. As rates rise, bond prices fall. You also have to be mindful of credit risk, the chance that a fund’s holdings will default on their obligations. You can mitigate some of the risk by looking for well-managed funds that hold high-quality bonds and don’t extend maturities very far.

Here are three bond funds that make worthy substitutes for stable-value funds. Two are members of the Kiplinger 25, and one is an index fund. The average credit quality of all three funds is single-A or better.

Managed by Bill Gross of bond powerhouse Pimco, Harbor Bond (symbol HABDX) has consistently topped its rivals. The fund, a member of the Kiplinger 25, has beaten the average intermediate taxable-bond fund nine out of the past ten years (including 2009 through August 31). Over the past ten years, it returned 7.2% annualized, outpacing its rivals by an average of two percentage points a year -- a huge discrepancy in the normally stodgy world of bonds. Gross and his team minimize risk by holding healthy doses of high-quality corporate bonds and cash.

The fund, which yields 3.9%, would lose about 4.8% of its share price if interest rates rose one percentage point. Since its inception in late 1987, the fund’s biggest one-year loss came in 1994, when it lost 3.8%. Harbor Bond earned 3.3% in last year’s difficult market. Its annual expense ratio is a below-average 0.55%.

The nine managers at Dodge & Cox Income (DODIX) seek out bargains in the corporate-bond market, taking advantage of the kind of irrational selling that was so prevalent last year. Also a member of the Kiplinger 25, the fund earned 6.6% annualized over the past ten years. That beat the typical intermediate-bond fund by an average of one point a year. Dodge & Cox topped the category average eight years out of ten.

The fund, which yields 5.5%, would fall about 3.9% if interest rates rose one percentage point. Like Harbor Bond, Dodge & Cox Income sustained its worst annual loss in 1994, losing 2.9%. In 2008, it lost 0.3%. The expense ratio is 0.4%, near rock bottom for an actively managed fund.

Index funds are boring. And that’s why a solid one, such as Vanguard Total Bond Market (VBMFX), makes a good alternative to a stable-value fund. Total Bond reliably tracks the Barclays Capital U.S. Aggregate Bond index, a broad benchmark of market performance for investment-grade bonds, and carries a low, 0.2% expense ratio. Total Bond, which yields 4.3%, returned an annualized 6.0% over the past ten years.

The fund holds more than two-thirds of its portfolio in government bonds and mortgage-backed bonds guaranteed by government agencies. If interest rates rose one percentage point, Total Bond would see its share price decline by about 4.3%. Since its launch in 1986, the fund’s worst year was 1994, when it lost 2.7%. Last year, it earned 4.6%.

High-quality bond funds, as well as stable-value funds, are for storing your mattress money, not for getting rich. If you want higher returns, invest in stock funds.