The world sticks with the U.S.

Bond experts say foreign investors will likely scoop up Treasurys to fund a bank bailout. The bad news is that higher interest rates may be the price we pay.

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By Paul R. La Monica, editor at large

What should Congress do with the $700 billion proposal to take pressure off the credit markets?
  • Pass the legislation quickly
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NEW YORK ( -- The so-called "flight to quality" in the U.S. Treasury market appears to be over for now - bond prices are down and yields are up from lows touched last week.

But is the selling in Treasurys a good sign that companies and investors are willing to take risk again? Or does it mean that foreign central banks are losing faith in the U.S. economy as the government tussles over the $700 billion rescue plan - and all the potential liabilities that go with it?

Several bond experts said that while the fears about what's next for the banking sector are a major worry, they don't see foreign investors pulling out of Treasurys en masse.

"The volatility is a concern for sure. But foreign central banks will stay with the U.S. market. Globally, Treasurys are still the best source of liquidity out there," said Steve Van Order, chief fixed income strategist with Calvert Funds in Bethesda, Md.

The Federal Reserve pointed out in its most recent weekly report on reserve balances at the nation's banks that foreign investors (central banks and private accounts) held about $1.45 trillion in Treasury securities as of Sept. 17, up $10 billion from a week earlier and up $239 billion from the same period last year.

"There is starting to be some stability in the Treasury market. The volume of Treasurys held by foreign investors is still very big," Van Order said.

Van Order added that he was also encouraged to see that foreign investors are looking to scoop up pieces of troubled financial firms as well.

British bank Barclays (BCS), for example, is buying much of the fixed-income and equity trading, research and investment banking businesses of bankrupt Lehman Brothers (LEH, Fortune 500) in North America.

Meanwhile, Japanese bank Nomura (NMR) announced Tuesday that it was purchasing the European and Middle Eastern equity and investment banking businesses of Lehman. Nomura said yesterday it was buying all of Lehman's Asian operations.

And also yesterday, Japanese financial giant Mitsubishi UFJ (MTU) said it was looking to take up to a 20% stake in U.S. investment bank Morgan Stanley (MS, Fortune 500).

Van Order said this is yet another sign that global investors are not giving up on the United States. "Foreign investors do appear to be committed to the U.S. market. There are assets here that are cheap and companies are trying to find value," he said.

Brian Battle, vice president of Performance Trust Capital Partners, a fixed-income trading firm based in Chicago, agrees that despite all the turmoil on Wall Street, there is still healthy demand for Treasurys and it should remain that way.

"If I'm a foreign investor and I decide I've had enough of the U.S. and I want to sell my dollars and Treasurys, then where do I go?" Battle said. "Worldwide interest rates are not that attractive and the money has to go elsewhere. The dollar is cheap."

Long-term yields may go higher

At the height of the panic last week, the yield on the 10-year Treasury hit a five-year low of 3.25%, but it's now up to 3.84%. The 3-month Treasury has gone from zero percent to 0.85%.

So where will bond yields go from here? If the bailout plan is passed, the government is likely to fund the purchase of bad bank assets by issuing more Treasurys.

That's on top of more debt that may be needed for the government's takeover of mortgage giants Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500) earlier this month as well as the $85 billion loan from the Fed to troubled insurer AIG (AIG, Fortune 500).

"You add this all up and it very quickly gets up to around a trillion dollars," said John Donaldson. vice president of Haverford Trust.

And even though experts think that international investors would scoop these new Treasurys up, the simple fact that there is more supply out there would probably lower prices and drive up yields.

"Ultimately, it's a question of the deficit. Interest rates may have to rise to clear up the debt down the road," Van Order said.

And unfortunately, the trade-off for saving the banking system could be an even weaker dollar, which could push up long-term rates even further and spark more inflation fears.

"A bailout is bad for the dollar since there will be more Treasurys," Battle said. "Yes, there will be demand. But investors will also demand more yield if there is more supply."

In other words, the bailout may prevent a widespread systematic failure of the banking system. But the cost is higher interest rates. Haverford's Donaldson said it's not that much of a stretch to think that the yield on the 10-year Treasury heads back above 4% in the near future.

And another bond fund manager even thinks the Fed will have to soon start boosting its key fed funds rate, currently at just 2%, to prop up Treasury yields.

"This isn't doom and gloom but the government will have to raise interest rates to keep foreign investors interested in Treasurys. They are now a poor value,"said John Lekas, founder and CEO of Leader Capital Management and portfolio manager of the Leader Short-Term Bond Fund. To top of page

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