Treasury Investors Go to Cash, Gold, Brazil

BOSTON ( TheStreet) -- The last-minute U.S. debt-ceiling resolution and the still-unresolved issues that go with it has cast a pall over the nation's once pristine Treasury bonds. Most spectacularly, the government bonds may lose their triple-A credit rating.

Investors are reacting by pulling out of investments that are heavy on short-term Treasuries, in particular money-market funds, and piling into sovereign debt and equities in countries with strong economies such as Germany as well as some emerging markets.

The U.S. House and Senate are expected to meet today to discuss increasing the debt ceiling by at least $2.1 trillion through the end of 2012, along with $2.4 trillion in deficit-reduction measures.

But since that falls far short of the $4 trillion in deficit reduction that Standard & Poor's said is necessary for the U.S. to keep its triple-A rating, it potentially faces the prospect of a downgrade from the rating agency.

Moody's, the nation's second-largest credit-rating firm, isn't expected to follow suit, however, as it is seen giving the U.S. more time to manage its deficit.

S&P said in a research note Friday that if the U.S. government's credit rating were to be downgraded, it would result in lower bond prices and higher yields. Still, 10-year Treasury yields fell 5 basis point to 2.74 percent today as a report showed manufacturing activity stalled.

A downgrade would send shivers through the bond markets since U.S. Treasuries are the benchmark for much of the fixed-income world and have historically been the safe-haven investment in times of international turmoil.

"In the possible, but hopefully unlikely, event that the sovereign-debt rating of the U.S. is lowered, we note that prices of funds with the greatest exposure to long-term bonds would suffer the most," Standard & Poor's Equity Research said in a research note published Friday.

The majority of bond funds typically rely on Treasuries as a cornerstone of their funds.

For example, the $6 billion Vanguard Intermediate Term Treasury Fund ( VFITX), which carries a top five-star rating from S&P, has significant exposure to Treasuries, at 80% of the portfolio and a 19% allocation to Fannie Mae and Freddie Mac bonds.

But bearing the brunt of the worries over a lower rating are money market funds, which are typically backed by short-term Treasuries and agency debt from Fannie Mae and Freddie Mac.

Investors in those funds are pulling out and going to cash, gold or into investments with foreign exposure.

EPFR Global, which tracks international fund flows, says over $140 billion has been pulled from money market funds since the second week of June.

Cameron Brandt, director of research at the firm, said that's because money market funds hadn't been earning much to begin with and then the added prospect "of some kind of selective default or freeze on government debt," which could impact investors' ability to redeem their funds on a timely basis, sent many skittish investors into other assets.

Money market funds still have about $3 trillion in assets so the redemptions, while certainly much larger than they have been so far this year, "couldn't be described as a panic," he said.

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