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Treasuries lose appeal for Asian, European investors

Section: Daily Dispatches

By Daniel Kruger and Kyoungwha Kim
Bloomberg News
Wednesday, September 24, 200

Investors outside the United States, who own more than half of all Treasuries outstanding, say the government's $700 billion plan to revive the banking system will diminish the appeal of the nation's bonds.

Treasury Secretary Henry Paulson's proposal, which seeks funds to rescue banks by purchasing devalued securities, would drive the country's debt to more than 70 percent of gross domestic product. The last time taxpayers owed as much was in 1954, when the U.S. was paying down costs from World War II.

"The image of U.S. Treasuries as a safe haven has been tainted by the ongoing financial debacle," said Kwag Dae Hwan, head of global investment in Seoul with South Korea's $220 billion National Pension Fund, which holds about $14 billion of U.S. government debt. "A big question mark hangs over whether the U.S. can deal with an unprecedented amount of debt. That is unnerving all the investors, including me."

The government depends on foreign money to finance the budget deficit, which UBS AG estimates will increase to $1 trillion next year from $407 billion if the bailout is approved. Investors outside the U.S. own 56 percent of the $4.8 trillion in marketable Treasuries outstanding, up from 42 percent of the $3.4 trillion outstanding five years ago, according to data compiled by the government.

... Keeping Rates Low

U.S. long-term interest rates would be 1 percentage point higher without demand from foreign governments and central banks, according to Professors Francis and Veronica Warnock at the University of Virginia in Charlottesville, who have done research for the Federal Reserve.

The benchmark 4 percent note due in August 2018 ended yesterday at 101 21/32 to yield 3.80 percent, according to BGCantor Market Data. The yield fell to 3.78 percent as of 6:50 a.m. in New York today.

Demand for all but the safest of government debt increased in the past two weeks as the government seized control of Washington-based Fannie Mae and McLean, Virginia-based Freddie Mac, the country's biggest mortgage finance companies, and agreed to take over New York-based American International Group Inc., the largest insurer. The bankruptcy of Lehman Brothers Holdings Inc., also located in New York, on Sept. 15 caused credit markets to seize up.

Yields on 10-year notes fell as low as 3.25 percent on Sept. 16 from the high this year of 4.27 percent on June 13. The rate on the three-month Treasury bill fell to as little as 0.02 percent on Sept. 18 as investors sought the safest securities.

... 'Unbelievably Expensive'

The drop in yields combined with the likelihood that the government will sell more debt makes Treasuries "unbelievably expensive," said Theodora Zemek, global head of fixed income at Axa Investment Managers in London, which has about 120 billion euros ($177 billion) invested in debt assets.

"There is little value other than panic value in government bonds," Zemek said. "We've potentially got a big sell-off."

While Treasuries of all maturities have returned an average of 4.2 percent this year, including reinvested interest, Japanese investors lost money on U.S. debt, according to Merrill Lynch & Co. index data. A yen-based investor would have lost 0.4 percent as Japan's currency strengthened 5.9 percent against the dollar.

The U.S. may have to borrow an extra $700 billion to $1 trillion to fund the bailout, according to Barclays Capital Inc. interest-rate strategist Michael Pond in New York. The proposal, sent to Congress Sept. 20, would increase the nation's debt ceiling by 6.6 percent to $11.315 trillion.

... New Deal

Paulson and Federal Reserve Chairman Ben S. Bernanke made their case for the plan to Congress yesterday, pushing for the biggest federal intrusion into markets since the New Deal. The Fed and Treasury failed to stem the credit crisis sparked by the collapse of the subprime mortgage market by cutting its target interest rate for overnight loans between banks to 2 percent from 5.25 percent in September.

"If the credit markets are not functioning," Bernanke told the Senate Banking Committee yesterday in Washington, "the economy will just not be able to recover."

The cost to hedge against losses on 10-year Treasuries with credit-default swaps stood at 26.4 basis points, up from 2 basis points when the credit markets began to seize up in July 2007, according to BNP Paribas SA prices. That's higher than countries including Germany, Japan and France.

Credit-default swaps are financial instruments based on bonds and loans that are used to speculate on a borrower's creditworthiness. An increase indicates deterioration in the perception of credit quality. A basis point on a contract hedging $10 million of debt for five years is equivalent to $1,000 annually.

... Deteriorating Economy

Treasuries may appreciate as a slowing U.S. economy and inflation sparks demand for fixed-income, according to some investors. Growth may decelerate to 1.7 percent this year and 1.5 percent in 2009 from 2 percent in 2007, according to the median estimate of 80 analysts surveyed by Bloomberg.

"Yields are driven by the economy, the financial system, and the inflation rate," said Robin Marshall, director of fixed-income in London at Smith & Williamson Investment Management in London, which oversees about $20 billion in assets. "I'm not sure supply will be the conclusive driver."'

Even with the economy slowing, the yield on the 10-year note has climbed from 3.25 percent on Sept. 16, which was the lowest since 2003, amid concern about increased debt supply and a widening budget deficit. The dollar has dropped 5.5 percent against the euro since reaching a one-year high on Sept. 11.

... Supply Concern

"Bond yields are reflecting supply concerns," said Felix Stephen, senior investment strategist in Sydney at Advance Asset Management Ltd., which oversees the equivalent of $6.56 billion. "The currency is also reflecting that, because global investors, predominantly the ones who will be buying this paper, want to make it as cheap as possible," Stephen said.

Stephen, whose International Fixed Interest bond fund returned 5.1 percent this year, beating 83 percent of its peers, said he expects the 10-year Treasury yield to rise to 4.75 percent in the second half of next year.

He may be right. Back in the 1950s, the last time debt as a percentage of GDP was as high as economists are now predicting, yields on long term government bonds rose to 4.27 percent from 2.32 percent, according to Sidney Homer's "A History of Interest Rates."

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