Part 2 - Time to get conservative with your 401K

Back in January when the market was going through its first set of gyrations and hitting a serious low I wrote a post titled "Time to get conservative with your 401K".

In that post I suggested that, in the interest of preserving capital, it might be a good idea to move approximately half of your 401K holdings into a stable value fund. It's true, this does have an element of market timing. On the other hand, there is nothing wrong with being defensive when it is clear that the market is in a serious downtrend. In fact, the post was somewhat inspired by the writing of Random Roger who advises that investors avoid allowing their portfolios to go "down a lot" though "down a little" is probably unavoidable in a down market.

With the Fed and the Treasury moving to support Fannie Mae and Freddie Mac, it is time to discuss this strategy again. At the time of the original post, there was a debate about the nature of the holdings of stable value funds. The funds are typically not very forthcoming on the specifics of their holdings. It is generally accepted, though, that most of these funds hold bonds, known as agency debt, issued by Fannie or Freddie. Agency debt generally holds the highest ratings, but investors have demanded a nominal spread over Treasury debt for perceived credit risk. These slightly higher spreads contribute to the higher interest rates offered by the stable value funds as compared to money market funds. As an indication of the safety of agency debt, however, the spreads are less than for other publicly traded companies since investors see government ties representing an implicit guarantee.

With Freddie and Fannie under pressure and accusations of insolvency being thrown about, I began to worry that stable value funds and some of the other so-called "cash" funds offered in 401K plans were perhaps not as safe as advertised. The stocks of the two GSEs have been decimated but the debt has been holding its value with spreads over Treasuries staying in a reasonable range.

Today, Freddie Mac offered $3 billion of short-term notes. This was not an unusual transaction but against the current backdrop it was looked at as somewhat of a test of investor confidence in the agency's debt. I was relieved to see that Freddie drew higher-than-average demand for the notes as the U.S. Treasury's rescue plan seemed to assure that the government will back the company's debt. The bid-to-cover ratio at Freddie's bill auction, gauging demand by comparing total bids with the amount of securities offered, was more than 50 percent above the average of the past three months.

In addition, the spreads have narrowed, showing that the market is pleased with the actions of the Treasury rather than alarmed.

So far, then, the stable value fund strategy is still safe. The debt of Freddie and Fannie retains its high rating and investor confidence. It may be wise, however, to dig into the stable value fund offered by your 401K plan to better ascertain the nature of its holdings. And just to be cautious, it would be reasonable to look at alternatives. For typical "flight to safety" purposes, a fund holding short-term treasuries or TIPS would be appropriate. You won't make much money in these kinds of investments but at least you can be pretty sure you will preserve capital.

For more on this topic, read Part 3.