Bond investors shrugged off budget showdown

April 11, 2011

There is one surprising group of people who are not terribly worried about the budget brinksmanship in Washington: the investors who lend the U.S. government billions of dollars.

Last week’s showdown (and near-shutdown) over funding the government through September was a high-stakes drama in Washington. The upcoming battle over raising the government’s debt ceiling is poised to feature more of the same, complete with dire warnings about the federal government defaulting on its debt.

But the market for Treasury bonds lately has been exceedingly calm. While the money managers who invest in those bonds say they monitored last week’s drama over a potential shutdown, it wasn’t the major driver of ups and downs in the market. Rather, prices moved based on the usual economic reports and new evidence about what the Federal Reserve will do next.

“The brinksmanship that we’ve seen so far hasn’t really affected yields as much as I thought it would,” said Brian Brennan, who manages three bond funds for T. Rowe Price.

“What the markets were discounting last week was an expectation that eventually we would see a deal from Congress and the president,” said Krishna Memani, who heads fixed-income investing at OppenheimerFunds and manages several bond funds. “That was the core expectation, and it was proved right.”

The U.S. government was able to borrow money for a decade at 3.58 percent Monday, up from 3.42 percent a week earlier but below February levels. An index of volatility in the Treasury bond market has in recent days been at its lowest levels since last fall.

Even as bond investors shrug off the brinksmanship in the short run, the nation’s most prominent bond investor has turned strongly negative on the outlook for U.S. government debt.

Pimco, the largest bond investor, disclosed over the weekend that its $236 billion Total Return Fund now holds negative 3 percent of its assets in Treasurys, meaning it would actually make money if Treasury bonds decline in value. The manager of the fund, William H. Gross, has written that the political environment is sufficiently toxic — and the nation’s longer-term fiscal problems sufficiently in­trac­table — that U.S. government debt is a bad deal.

“Unless entitlements are substantially reformed, the U.S. will likely default on its debt,” Gross said in an April report. “Not in conventional ways, but via inflation, currency devaluation and low-to-negative real interest rates.”

Prices in the bond markets — the low levels of return that investors are willing to accept — suggest that investors broadly are not buying Gross’s thesis for now. They are betting that, one way or another, the government will reach an agreement on reducing the long-term budget deficit before the nation’s fiscal problems become insurmountable.

In the shorter run, Congress will need to raise the nation’s debt limit by next month or it would make it hard — and eventually impossible — for the federal government to pay its bills. The Obama administration and its allies have described the need for congressional action in near apocalyptic terms.

“Default would cause a financial crisis potentially more severe than the crisis from which we are only now starting to recover,” Treasury Secretary Timothy F. Geithner said in a letter to Congress last week.

Bond investors generally are confident that, when all the political posturing is over, a deal will be done on the debt ceiling and their investments will be safe. But they acknowledge some wariness.

“I think it would be pretty dire if it came to the point where we have extended weeks of alternate methods to fund the deficit,” Brennan said. “If politicians do that, they have to realize it’s not going to be good for the economy and will make everybody look bad.”

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