Stable value funds, a capital preservation vehicle popular with 401(k),-reached an all-time high of $646 billion at the end of last year, according to a report released Monday by Cerulli Associates.           

In a review of the mutual fund and ETF market, Cerulli gave a few reasons for the value funds reaching these heights, but also cited a few caution signs for advisors to note.

The instruments, in which asset managers, banks and insurers put a book-value guarantee, known as the "wrap," around a bond portfolio, endeared themselves to investors by weathering the market crisis of 2008 very well. These products aim to provide the liquidity of money market funds, but with better returns, stabilizing the principal and smoothing the yield as rates gyrate. This steady income served investors in good stead in 2008. The products also benefitted from regulatory changes from the Department of Labor on qualified investments.

However, Cerulli notes there are two key issues affecting stable value funds: the capacity for the wrap, plus regulatory concerns.

The market's capacity is strained because three major providers of wraps - UBS, AIG and Rabobank, which together accounted for 11% of the market - decided to pause or exit the business. Providing this kind of insurance requires a commitment in tough times, because when the ratio between the market value and the guaranteed book value of the funds falls, the insurers are obliged to make up the difference. 

The industry was lucky in 2008, when ratios fells below 90%  (a healthy ratio is around 100%) that most investors were happy to get their steady stream of income and didn't demand redemptions from the funds. As of June, the ratios were back to a healthy 103.7%.

Still, the exiting of three big players nudged fees on the products from single digits to 15-20 basis points. This higher price tag lured new companies into the market. A survey this spring found an anticipated offering of between $67 billion and $100 billion in new capacity this year, from a total of 18 companies.

What's more, regulatory reform after the credit crisis could prove a problem for stable value funds. The Securities and Exchange Commission and U.S. Commodity Futures Trading Commission are now figuring out whether stable value funds should be classified as swaps, which require tougher regulation. If so, they could carry additional costs and become more expensive. What's more, if rule changes reclassify fund providers as swap dealers, they will be considered fiduciaries for the retirement plans that use their products. Paradoxically, that means they will not be able to use interest rate swaps. That will drive up the cost of hedging interest rate volatility, according to the Cerulli report.

"In the worst-case scenario, such an interpretation could force wrap providers to desert 401(k) plans," the report said. But it added that even so, all contracts begun before the regulatory change will be grandfathered and exempted from the regulation.

The report ended by saying that likely rate increases in the next few years will tighten the spread  between stable value funds and other short-term investments in 401(k) plans. Given that, plus regulatory uncertainty, short-term bonds may look like better choices for 401(k) plan participants.