Meltdown 101: Who invests in a zero-interest bond?

[December 11, 2008]  WASHINGTON (AP) -- The demand for Treasury securities -- investments where the investor lends money to the federal government -- has become so frenzied that yields have fallen to minuscule levels. At one point this week, the interest rate on one such investments even hit zero.

Zero. As in, the rate of return you'd get if you locked a stack of 20s in your basement.

First, on Monday, the government's sale of three-month Treasury bills brought an interest rate of 0.005 percent. The zero rate came the next day, when the government sold a batch of four-week bills. Both rates were record lows.

Who exactly puts money into Uncle Sam's bills and bonds? And why would they make investments that offer little or no return?

Here are some questions and answers about what is happening in the bond market.

Q: Who would be dumb enough to buy Treasury debt that is bringing such low rates?

A: Plenty of people. The demand for four-week bills at Tuesday's auction was so high that the government could have sold four times as much as the $30 billion in debt that it did sell.

Q: Why would investors be behaving in this manner?

A: One word -- fear. The current financial crisis, the most serious since the Great Depression, has seen investors lose trillions of dollars on their other investments as Wall Street and stock markets around the world tanked. Those huge losses have made investors extremely nervous about putting their money anywhere that isn't super safe.

"At the moment, global investors are willing to take no interest rate because they are nervous and scared," said Mark Zandi, chief economist at Moody's Economy.com. "They just want to be sure they get their money back."

Q: And who are these investors?

A: Institutional investors and foreign central banks dominate the market for Treasury securities -- although small investors play a role, since so many have pension funds and money market mutual funds that, in turn, invest in the bills and bonds.

Q: How much of a stake do foreign governments control in Treasury securities?

A: According to U.S. government data, about half of the nation's $5.3 trillion in publicly traded debt is held by foreign nations, with China recently passing Japan as the country with the largest holdings.

Q: Why do foreign governments pour so much money into Treasury securities?

A: Even though the global financial crisis began in the United States, holdings of U.S. government bonds are still viewed as the safest investments in the world. There are lots of bonds available for purchase -- the national debt stands at $10.59 trillion, and growing -- and the U.S. has never once failed to meet a debt payment.

Q: Besides security, what do foreign governments get for their U.S. Treasury holdings?

A: For one thing, it provides them with a hedge against a loss of value in their own currencies. Let's say country A buys three-month Treasury bills, and its currency then declines in value against the U.S. dollar. The country would come out ahead on its dollar-denominated Treasury securities because they would be worth more relative to the country's own falling currency.

Q: Why else would a foreign government hold Treasury securities?

A: The U.S. trade deficit plays a role. Those deficits mean billions in American currency are being transferred to foreigners, who are perfectly happy to take dollars in return for the televisions and cars they sell to American consumers. But the dollars have to go somewhere, and Treasury securities are a safe investment.

Q: What about other big institutional investors?

A: Money market mutual funds, pension funds and state and local governments also have big holdings in Treasury securities, again in large part because they represent safety.

Since the stock market collapse in September, investors have been avoiding the stock market and putting billions of dollars into money market mutual funds. The managers of those funds have to do something with that money and the safest bet is to buy Treasury securities.

Q: When Treasury rates get so low, are there other safe options for central banks and institutions with huge sums of money to invest?

A: The Treasury market is attractive to large investors because of its safety and its size. It is a convenient place to park large sums of money without losing sleep at night.

Other alternatives -- such as bonds issued by corporations or debt backed by mortgages, consumer credit cards or auto loans -- have lost appeal because of all the turmoil in financial markets.

Q: If Treasury interest rates are already at or near zero, could they go into negative territory -- meaning investors would be paying the government for the right to put money into Treasury securities?

A: Economists don't think the situation will reach that point, although they're not ruling anything out.

They do believe Treasury interest rates are likely to remain low for some time because they think the economy will remain in recession until the middle of next year. And as long as investors aren't feeling confident about the stock market, they will likely keep flocking to the safety of Treasury securities -- and that demand should keep rates low.

"In my 30 years as an economist, I have never seen the fear factor as high as it is currently," said Sung Won Sohn, an economist at the Smith School of Business at California State University.

[Associated Press; By MARTIN CRUTSINGER]

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