US debt: Are companies (corporate bonds) a better bet than treasuries?

1st August 2011

Investors in treasuries should note first that the two Houses of the US Congress – one Democrat controlled, one Republican controlled – must vote on the deal before it is sealed.  Second, they should remember that the US's behaviour in the last few weeks makes a downgrade more likely anyway.

Certainly the world's largest bond fund manager Pimco believes there will be a downgrade from at least one of ratings agencies as the Telegraph reports.

The paper quotes Pimco boss Mohamed El-Erian saying: "I think this compromise will lead to an increase in the debt ceiling, and therefore avoid default. We have one rating agency out there that said it would downgrade unless certain things happen, and these things are not happening fast enough. If the US loses that AAA status it will be much more difficult for it to restore growth, so it is unambiguously bad."

So does this mean that those who have held US treasuries as the ultimate safe haven, should consider moving?

MarketWatch suggests that ultimately even with a downgrade many will keep double AA rated treasuries, partly because the market is so deep and liquid and because they may lack alternatives.

This extends to banks, institutional investors and indeed countries that hold large amounts of treasuries including China and Japan though long term some countries may increase the pace of diversification.

The website says that the threat of default or a downgrade are "nerve-wracking possibilities raising serious questions about investor savings – much of which has been hanging out in cash equivalents, such as money-market funds – and income-producing investments such as bonds. Either way the bulk of these investments is highly sensitive to moves in Treasury rates."

At the edges, at least, markets were starting to react on Friday.

The New York Times reported uncertainty surrounding short term US Treasury bills which were trading at significant discounts.

The bills are basically a US Government promise to $10,000 at a future date. But as the newspaper reports – "Under normal circumstances, of course, a bill that matures a month from now would cost a little less than one that matures next week. But that was not true on Friday. The $10,000 bill that matures this Thursday traded for as little as $9,970.50, a discount of $29.50. But a bill that matures Sept. 29 – eight weeks later – never traded for less than $9,991.50, a discount of $8.50."

The Wall Street Journal reports that junk bonds, bonds below investment grade, have received a boost. This means bonds that are from either already relatively indebted firms or emerging markets are receiving a big boost, mostly manifesting itself in increased sales of US mutual funds that invest in this type of security.

The reason is that better rated corporate bonds could move in line with treasuries in the event of a default.

The paper reports that "Money has been pouring into funds that invest in high-yield corporate debt, and those that buy emerging-market debt. High-yield bond mutual funds took in $2.8 billion in July, including $304 million this week, following a dismal June, according to data from Lipper. Emerging market funds took in $650 million last week. By contrast, investors took $32 billion from short-term money market funds and $2 billion out of stock-market funds."

Here on Citywire, Pimco made waves earlier this year when it suggested that investors needed to take both treasuries and gilts out of model portfolios.

Citywire Editor Gavin Lumsden considers some of the asset allocation decisions investors may make.

He suggests among other things that a cash buffer is advisable and that gold remains a suitable hedge, (not all commentators agree) and that bonds from Scandinavia and Asian countries may make sense as replacements.

However as markets experience short term jitters, investors genuinely considering a fundamental shift in any funds or portfolios would do well to consider seeking professional advice.

See also:

US debt: Obama announces deal, but Congress still needs to vote

Why the U.S. won’t default on its debt

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