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'Flight to Mediocrity': Bonds to Get Test Amid Debt Debate

If the Washington conflict over raising the debt ceiling poses a real threat to government bonds, somebody forget to tell the traders who power the $3 trillion market.

AP

The various securities the government issues to cover its debt—short-term bills, longer-term notes and the 30-year bond—have held their prices throughout the political acrimony, keeping yields low and auctions well-subscribed.

This despite the precarious nature of US finances, complete with a $14.3 trillion debt and a budget deficit at $1.3 trillion.

Inflows to taxable bonds are averaging $4.46 billion a week, according to Lipper, even as many debt experts bemoan the financial conditions of the government backing the securities.

"You have to call it a flight to mediocrity in this environment," Kevin Ferry, president of Cronus Futures Management in Chicago, said in a CNBC interview (see video below). "These securities are being used as collateral around the world. There's an uneasy stability in the market. I don't think the politicians should take that as any type of green light to allow this to continue."

This week's auctions, which kicked Tuesday with a $35 billion sale of two-year notes that will be part of a $99 billion series of sales through the week, could go a long way towards determining whether that uneasy peace in the bond market continues.

"A sloppy auction will set the tone for two more sloppy auctions throughout the week," Ferry said.

But the two-year sale went fairly decently, with the yield on target and demand a bit lower than expected but still respectable.

The stalemate over whether Congress should raise the $14.3 trillion debt ceilinghas come with a hefty supply of brinkmanship and threats of armageddon.

Among the dangers that government officials have stressed if a political agreement is not reached are a rise in interest rates and a global loss of faith in US creditworthiness.

Yet the yield on the 10-year Treasury note hasn't been north of 3.25 percent since early May, when fears intensified that defaults in Greece and throughout the euro zone peripherywould infect the US.

In fact, worries of euro debt default had a more negative impact on Treasurys than the debt situation in the US.

"The sentiment right now is that it's the best alternative out there," said Kim Rupert, managing director of global fixed income analysis at Action Economics in San Francisco. "You don't really want to be buying Greek bonds, for instance. What other kind of debt instruments can you buy? Bonds are about the only thing. There's not a lot of concern that even if Treasurys are downgraded there would be wholesale selling."

A lack of agreement on the debt ceiling actually would benefit Treasurys in the short term as investors likely would pile into the safety bid if there was a threat that supply would be cut off, Rupert added.

Rather than take out the debt imbroglio on the debt markets, investors instead have attacked the dollar.

The US currency is seen as continuing its steep declineshould the debt ceiling not be raised by early August, a development that could usher in inflation, which in itself would not be bond-friendly.

"The market is expressing its discontent with congressional partisanship in the dollar rather than in the Treasury market right now. It's pretty obvious," said Jessica Hoversen, fixed income analyst at MF Global in New York. "The concentric impact on Treasurys could be as a safe haven. We have to ask ourselves where money is going to go even if Treasury doesn't hike its debt ceiling."

Indeed, the bond trade has remained resilient despite a series of obstacles. In addition to a seeming overabundance of supply there has been a legion of doubters, most notably Pimco, the Newport Beach, Calif.-based firm that runs the largest bond fund in the world.

Pimco has shed most of its Treasurys holdings, believing that the anemic yields don't justify tying up money in a country with a balance sheet as damaged as the US while other countries promise better returns with more security.

Yet Pimco missed a nice gain in Treasurys—something for which it is not apologetic—as investors continue to flock to US debt, bad balance sheet and toxic political environment be damned.

"There are better places," Hoversen said. "I'm not sure I want to lock my money up for 3 percent for 10 years. The valuation is poor. But the US will plug along here."