The week started off on a sour note when, on Monday, Standard & Poor’s put the federal government on credit watch with a negative outlook, meaning there’s at least a 1-in-3 chance the agency will downgrade Uncle Sam’s AAA bond rating within the next two years. The market responded with a triple-digit sell-off on the Dow Jones Industrial Average as investors fled stocks. You’ve got to admire his chutzpah.
How did the government respond? Well, on Tuesday, Treasury Secretary Timothy Geithner said he saw “no risk” that the United States would lose its top credit rating. Makes you want to ask: How do you know, Timmy? What could you do to stop the rating agencies if you wanted to?
Obviously, there’s more than a trivial risk (regardless of what Geithner says) that S&P will follow through on its threat — and that global investors will start to demand higher yields on U.S. government debt to compensate for a perceived loss of credit quality.
However, any such developments are still many months off in the future. In fact, if S&P’s warning helps scare President Obama and Congress into mending their fiscal ways, the downgrade may even be averted.
For now, anyway, Treasury bonds are trading buoyantly, with the typical long-dated government IOU up 3.5 points in the past six sessions. It seems a few clever investors have figured out that when the Federal Reserve wraps up its second round of “quantitative easing” in June, the economy will probably downshift to a slower growth phase, as it did when QE1 ended a year ago.
If the benchmark 10-year Treasury yield bounces back to 3.5% or higher, I may even recommend buying some government paper for a trade. In the meantime, you’re better off with mortgages, emerging markets bonds and other instruments that throw off a significantly richer yield than Treasuries.
The best value right now is the Western Asset Emerging Markets Debt Fund (NYSE: ESD). Yielding 7%, ESD puts twice as much cash into your pocket, over the course of a year, as a 10-year T-note. That extra yield gives you something of a cushion against rising interest rates, which would depress the resale value of most bonds.
