NEW YORK (MarketWatch) -- Treasurys gained Wednesday, pushing yields on the shortest-term securities to the lowest in decades, after the Commerce Department said housing starts declined more than expected, indicating a continuation of the housing recession that is weighing on a growing number of financial institutions.

U.S. debt also rallied as a resurgence of fear in other debt markets and equities led to safe-haven Treasury buying.

Two-year notes yields fell TMUBMUSD02Y, 0.128% 18 basis points, or 0.18%, to 1.63%.

Rates on three-month bills, among the most popular assets for investors seeking higher quality, plunged to 0.06%, the lowest on record.

Housing starts fell 6.2% to a seasonally adjusted rate of 895,000 in August, the lowest in 17 years.

That is also below the 955,000 forecast by economists surveyed by MarketWatch. Building permits, another sign of future construction, also dropped. See full story.

"The key here is that starts and permits are exhibiting another leg down, which will keep dragging on residential investment" and economic growth, said T.J. Marta, fixed income strategist at RBC Capital Markets.

Treasurys initially were lower after the Federal Reserve bailed out American International Group AIG, -1.23% to avert a potential bankruptcy of the insurance giant. See full story.

The Fed's offer of an $85 billion loan to AIG revived concerns among bond investors that the government will have to issue more debt, decreasing the value of their current holdings.

"Initially, the bailouts and financing seem like a good thing for the system -- they buy time, soothe panic," said RBS Greenwich Capital strategists. "But it will put a lot of paper into the market at distressed levels that surely impact the pricing of more solid institutions' holdings."

Already, the Treasury Department auctioned $40 billion in 35-day cash management bills at a rate of 0.30% to deposit at the Fed to finance its liquidity operations. See full story.

Benchmark 10-year note yields fell TMUBMUSD10Y, 0.646% 6 basis points to 3.39%. Prices move in the opposite direction of yields.

Yields on 30-year bonds, the longest security the U.S. issues, dropped TMUBMUSD30Y, 1.417% to a record-low of 4.07%.

Corporate borrowing costs increased as investors fled riskier assets.

The gap between two-year treasury yields and the two-year swap rate, a fixed-rate payment made to receive a floating rate, jumped to 129.5 basis points today from 94.5 basis points on Friday afternoon, according to UBS.

Fed futures

Treasurys ended lower Tuesday after the central bank disappointed markets and kept its target interest rate at 2%.

Traders see a 64% probability that the Fed will lower rates at least a quarter percentage point at its next meeting on Oct. 29, according to the November fed funds futures contract.

Traders also expect a second quarter-point cut at policy makers' December meeting.

Fund managers outlook

The number of fund managers taking the view that the global economy is in recession rose sharply in September.

The number of fund managers that believe the global economy is in recession rose to 44% in September, according to a monthly survey by Merrill Lynch. That level of gloom is up from 24% in August. The survey of 186 mangers who oversee a total of $641 billion took place after the Treasury Department seized mortgage giants Fannie Mae FNM, and Freddie Mac FRE, -0.64% .

Investors went overweight bonds for the first time in the survey's history, with 4% of managers taking this view, compared to a net 14% underweight position last month, Merrill said. See related news.