Bond investors search for answers in US debt crisis

Pension funds call in their advisers amid confusion over the possible effects of a credit rating downgrade on Treasuries
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The cost of insuring against a US default soared yesterday and global investors drew up contingency plans for a world in which the largest economy loses its gold-plated AAA credit rating.

Pension advisers say worried funds are asking for information about how they should respond to a downgrade, and one of the UK's leading consultants predicted a ratings downgrade on US Treasuries would trigger a major sell-off of American sovereign debt.

As crucial negotiations to raise the US debt ceiling remained deadlocked, Andrew Kirton, the chief investment officer at the Mercer consultancy, said that institutional investors were increasingly asking him whether they should sell holdings of US Treasuries.

"I have had lots of conversations with clients who say they are nervous about the prices they are having to pay for Treasuries, considering their growing level of risk," he said. "A significant proportion of institutions think Treasuries look overpriced and, while they are not going to dump them, they will consider selling some of them. They may well also defer buying additional Treasuries, especially if there is a downgrade."

A downgrade became more likely as the US edged closer to next Tuesday's deadline, when it must agree to raise its $14.3 trillion (£8.7trn) debt ceiling, or run out of cash.

The cost of insuring one-year US Treasuries, through credit default swaps, jumped by 8 basis points to a record 85 basis points. The spread between American and German sovereign debt – or the extra interest needed on US debt to compensate for the perceived additional risk of ownership – grew to 32 basis points, the highest level since February.

Most pundits still expect Republicans and Democrats to agree at the last minute the package of cuts and tax rises needed push through the debt increase that both parties want. But Standard & Poor's said two weeks ago there was a 50/50 chance it would cut its rating on US Treasuries in the next 90 days, and even if the ceiling is raised it must be accompanied by "credible" long-term deficit reduction. Yesterday the agency said it would not respond to pressure to reveal its thoughts on the matter on a day-by-day basis.

Pension funds and investment banks are trying to draw up contingency plans, but are finding it hard to get usable advice. Many operate under rules listing the kind of bonds that are acceptable to use for investment or as collateral, some of which stipulate that a certain proportion be held in AAA-rated debt. But advisers are split on the effects of a downgrade. Opinion runs the gamut from predictions of a Lehman Brothers-style market meltdown to a Y2K-style damp squib.

Sorca Kelly-Scholte, a pension fund expert at Russell Investments, the consultant, said: "Any downgrading of US Treasury stock wouldn't necessarily force a change of investment, and we're not seeing many funds worrying about this right now." By contrast, a senior lawyer who advises international investment bodies and fund managers, said he had been talking to worried investors. "A downgrade would put a lot of organisations in breach of their mandates and we are talking to them about this. People are in a tunnel and a train is coming, but nobody quite believes it's going to happen. It could well happen."

Stephen Lewis, the chief economist at Monument Securities, said: "The telephone lines are hot with talk, between the US, the European authorities, the Japanese, the Chinese."

Perceived safe-haven investments such as the Swiss franc and gold have risen, and yesterday the US equity market fell 2 per cent, but it remains close to year-highs.

"At the moment, investors are giving the US the benefit of the doubt," Mr Kirton remarked, "but on both sides of the Atlantic they are becoming more disenchanted and are looking to diversify their portfolios into other forms of debt, such as AAA-rated corporate bonds."