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What the Downgrade Means for U.S. Treasurys

In market turmoil like we've seen in the past weeks, investors frequently adhere to a simply playbook: sell risky assets and buy investments deemed to be safer. Typically that leads investors to dump stocks and put money into safe havens like cash, gold or government bonds. After all, stocks can fluctuate wildly, and individual stocks can ultimately go to zero. (Lehman Brothers stockholders were wiped out entirely when the crisis hit in the fall of 2008.) Bonds, by contrast, offer regular, fixed interest payments and a guarantee to return the principal. U.S. government bonds had always been the ultimate safe haven, as they come with the backing of the full faith and credit of the world's largest and most powerful economy.

But  Standard & Poors' decision to downgrade America's debt rating last Friday from AAA to AA+ may cause investors to think twice. So it's worth considering what the downgrade and the recent, somewhat counterintuitive action in the bond market mean for investors seeking safety.

What do Treasury bonds pay now? Very little.  To see what different government bonds yield, check out the data at the Treasury Department's website. As of yesterday, government bonds maturing in one month pay an annual interest rate of .02 percent; five-year bonds pay an annual interest rate of .93 percent, while 10-year bonds pay 2.17 percent. These are extraordinarily low returns. But they still pay a smidgen more than a typical bank savings account. Bank certificates of deposit that are federally insured (check out Bankrate.com for rates) of similar duration generally pay slightly lower interest rates than government bonds. But in this climate, it may be possible to find some that pay a bit more. In general, it's best to remember the basic rule on all fixed-income instruments: greater safety and a shorter term generally translate into lower interest rates.

Does the S&P downgrade mean that it is now riskier to buy U.S. government bonds, or bonds of states and cities? In theory, yes. Or at least that's what S&P was implying. Ratings are supposed to be indicators on the relative confidence the agency has that investors will be paid back. But there's a wrinkle here. The two other main credit rating agencies, Moody's and Fitch, have maintained their high U.S. government rating. In addition, the federal government differs from, say, a company whose debt S&P might rate. It has the power to print money and to raise taxes, and has plenty of revenues and resources it can use to make good on its interest payments. Even after the downgrade, nobody really believes the U.S. is less likely to keep current on its debt than it was a few weeks ago.

What's more, the market generally seems to have shrugged off S&P's warning. In the past several days, rather than rising —- as one would expect interest rates of a downgraded entity to do —- the interest on U.S. government bonds has fallen rapidly. In other words, investors seem to have responded to the downgrade by expressing more confidence in the asset. It's as if a restaurant received a negative rating on its cleanliness, and the next day people lined up around the corner.

So if buy government bonds today, I'll be getting a lower rate than before the downgrade? Yes. And that's one of the ironies of this situation. This shows that ratings are only one of many factors that impact prices and interest rates. Given S&P's less-than-stellar reputation, and the unique role that the U.S. government occupies in the credit markets, a simple rating change alone wouldn't be expected to have a huge impact. We have to consider the other factors that have been influencing bond prices in recent weeks.

There's a global flight to safety. Even downgraded, the U.S. remains a comparative bastion of stability in an uncertain world. Government bond markets are huge, and highly liquid, meaning it is easy to get in and out of them quickly. The U.S. government has always paid its debt. The dollar, while generally weak, is not the sort of currency that crashes 10 percent overnight. And so whenever something bad happens in the world —- an earthquake in Japan, instability in London, problems with European debt, uprisings in Arab countries —- investors around the world rush to buy U.S. government bonds. That pushes prices up and interest rates down. That's what has been happening in the past couple of weeks.

But it's not just about what is happening in the rest of the world. Aren't bond prices influenced by trends in the U.S. economy? Yes. Inflation —- and the fear of inflation —- tend to push interest rates up, while concerns about growth tend to push them down. These factors have been helping to keep interest rates on government debt low in the aftermath of the downgrade. The brinksmanship and uncertainty sown by the debt ceiling debacle, the promise of large budget cuts to come, and general concerns about economic malaise have pushed economists and investors to ratchet down their expectations for growth in the U.S. in recent weeks. What's more, with the continuing fall in energy prices —- a function of concern about a global growth slowdown —- inflation fears have ebbed. These three forces are powerful factors that help push U.S. government interest rates down.

How will interest rates be affected by the Federal Reserve's plan to keep interest rates low? The nation's central bank is yet another wild card influencing rates. In recent years, the Federal Reserve has been enormously influential in helping to dictate the prices of bonds. It controls short-term interest rates by buying and selling very short-term securities.  At other times, it can do the same with longer-term debt. As part of its first round of quantitative easing, for example, the Fed bought $1 trillion in long-dated mortgage-backed securities. In June, it finished its second round of quantitative easing, conjuring up money to buy $600 billion in U.S. government bonds, focusing on those that mature in five to seven years. The transparent point of this was to push interest rates down. So the Fed can be a very influential player in certain parts of the bond market. The Fed announced on Tuesday that it is planning to keep very short-term interest rates at their current low level through mid 2013. But it did not signal that it plans to embark upon other efforts to buy large quantities of longer-dated debt.

What's the best way to buy bonds? This is ultimately a matter of preference. The U.S. has created a vast amount of debt in recent years, which means investors have plenty of instruments to choose from, ranging from one-month out to 30 years. The Treasury Departments afford individuals the opportunity to buy bonds directly from the government through its Treasury Direct site. Online brokerage firms permit individuals to buy and trade bonds, just as they do with stocks. For customers not interested in simply buying and holding onto bonds until they mature, mutual fund companies like Pimco offer actively managed bonds funds. Investment companies have also rolled out a host of U.S. bond exchange traded funds.

Daniel Gross is economics editor at Yahoo! Finance.

Email him at grossdaniel11@yahoo.com; follow him on Twitter @grossdm.