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Yesterday, for the first time ever, Standard & Poor’s lowered its long-term outlook for the U.S. Government’s fiscal health from “stable” to “negative”, and warned of serious consequences if lawmakers fail to reach a deal to control the massive deficit the country has racked up over the past decade. The warning, which lasts for two years, essentially means that S&P believes there is at least a 33% chance that the agency will strip the U.S. of its top rating.

What is scary is that U.S. Treasuries (the debt of the United States), have essentially been considered risk-free assets for the past 50 years. If all of the sudden there is a perception that this is no longer the case, it will mean a massive shift in the way the global financial system operates.

How has this come to be? Well, the political gridlock in Washington has led to a game of brinkmanship around the debt ceiling (which needs to be acted on in the next two weeks), a failure to pass a solid budget, and no consensus whatsoever about how to start reducing the deficit by either cutting spending or raising taxes.

Stocks Tank and Treasuries Rise?

So why, then, on the day this was all announced did stocks tank over 1%, and Treasuries rise? Didn’t S&P just say that U.S. debt is becoming more risky, and there is a chance of default? Why would people rush to buy more of this product?

Well, the sad part is that nobody does believe that the U.S. government will default; not yet, in the short-term, at least. What most investors in the short term do see happening is a slow-down of the U.S. economy, similar to the UK, due to the austerity measures that will most likely start occurring over the next few years. Furthermore, with everything that has taken place in Japan, there is no doubt that GDP growth will be stagnant until at least the Fourth Quarter.

So, stocks look bad right now, but why not sit in cash, or government debt of another country (maybe China?). Well, there is another, potentially bigger problem that could plague U.S. investors.

The Mutual Fund/ETF Problem

The real reason there was so much capital inflow into U.S. debt in the wake of the news has to do with what I am labeling The Mutual Fund/ETF Problem. The problem is that the majority of U.S. based mutual funds and ETFs have specific rules written into their prospectuses that state what they can and cannot invest in. Specifically, each fund lists in its prospectus what it will and will not invest in. For example, a well-known popular fund has stated:

“The Fund invests 60% to 70% of its assets in dividend-paying and, to a lesser extent, non-dividend-paying common stocks of established, medium-size and large companies. In choosing these companies, the advisor seeks those that appear to be undervalued but have prospects for improvement. These stocks are commonly referred to as value stocks. The remaining 30% to 40% of the Fund’s assets are invested mainly in fixed income securities that the advisor believes will generate a reasonable level of current income. These securities include investment-grade corporate bonds, with some exposure to U.S. Treasury and government agency bonds, and mortgage-backed securities.”

The problem is highlighted when market conditions tell “reasonable advisors” that they need to seek safe investments that will not lose value so that they can preserve the capital and returns of their fund. Since they are limited on where they can go, they go and buy historically safe Treasury securities, even though that may not be the case going forward.

As a result, when S&P announces that Treasury securities now do run a risk to investors, and the market get spooked, large pools of money still flood into Treasury securities. It really makes no sense, but at the same time perfect sense since institutional investors such as mutual funds are limited as to where they can “safely” put their fund’s money.

The Solution

For individual investors, and even funds, over the long term stocks are the better investment over Treasury Securities, especially given the “newly defined” risk of owning them. Why hold debt of a government that is terribly mismanaged? You wouldn’t own a company in the same situation! Instead, look for high-quality dividend paying stocks. If you need a safe place to store cash in the short term, look at a bank CD ladder that is FDIC insured.

There are options out there, but why run the risk of owning U.S. debt when so many of the world’s greatest debt investors/raters (PIMCO’s Bill Gross, S&P), are so wary of U.S. debt?