By Sandra Hernandez

Sept. 17 (Bloomberg) — U.S. Treasury three-month bill rates dropped to the lowest since World War II as a loss of confidence in credit markets worldwide prompted investors to abandon higher-yielding assets for the safety of the shortest- term government securities.

Investors pushed down the rate to 0.0203 percent on concern that credit market losses will widen after the bankruptcy of Lehman Brothers Holdings Inc. and the federal takeover of American International Group Inc. In a sign of banks’ reluctance to lend, the rates charged for short-term loans relative to U.S. bill rates rose to the highest on record.

“It’s scary,” said E. Craig Coats Jr., who co-heads fixed income at Keefe, Bruyette & Woods Inc. in New York and started trading bonds in 1969. “This is the worst it’s ever been since I’ve been in the business. Nobody knows what’s really going on. Systemic risk is here and there and everywhere.”

Three-month bill rates fell 65 basis points to 0.041 percent at 5:15 p.m. in New York, after earlier touching 0.0203 percent. They had dropped to 0.3867 percent on March 20, after the Federal Reserve and Treasury engineered the takeover of Bear Stearns Cos.

The Treasury sold $40 billion in 35-day debt today under a new program that will allow the central bank to keep pumping cash into the banking system after its takeover of AIG. Funds from the sales will be kept in a Fed account. The bills drew a rate of 0.3 percent. Another $60 billion will be sold tomorrow, $30 billion in 20-day bills and $30 billion in 76-day bills, the Treasury said.

Money Markets

“People are extremely cautious with respect to who they’re lending money to at the moment,” said Richard Bryant, a Treasury trader at Citigroup Global Markets Inc., one of the primary dealers that trade government debt with the Fed. “They’re willing to buy very short-dated Treasury instruments and forgo returns and in some cases pay for the privilege of knowing their money is safe.”

The three-month bill rate has averaged about 3.44 percent in the last decade. It touched 0.01 percent in January 1940, monthly figures on the Fed Board of Governors’ Web site show, as investors sought the assurance of getting their principal back. Daily figures only go back to 1954.

Reserve Primary Fund, the oldest U.S. money-market fund, yesterday became the first in 14 years to expose investors to losses after writing off $785 million of debt issued by Lehman.

Shareholders pulled more than 60 percent of the fund’s $64.8 billion in assets in the two days since Lehman folded. Losses on the securities firm’s debt forced the fund to break the buck, meaning its net asset value fell below the $1 a share price paid by investors.

Borrowing in Dollars

“The panic going round the money market world is what they’ve been investing in is not as safe as they thought it would be,” said Dominic Konstam, the head of interest-rate strategy in New York at Credit Suisse Securities USA LLC, another primary dealer. “If the banks don’t want to lend to each other they don’t want to lend to the banks. That means where else are they going to put their money — they’re going to put it in T-bills for safety.”

The cost of borrowing in dollars for three months jumped the most since 1999 as banks hoarded cash. The London interbank offered rate, or Libor, rose 19 basis points to 3.06 percent, the British Bankers’ Association said. The increase is the biggest since Sept. 29, 1999, during the run-up to the new millennium.

The jump in Libor and rising demand for bills widened the gap between what the U.S. and banks pay to borrow in dollars for three months to the most since Bloomberg began compiling the data in 1984. The so-called TED spread soared 84 basis points to 302 basis points. It was as low as 75 basis points on May 27.

Credit Default Swaps

“I’m extremely worried about what is happening to the money market mutual funds that have announced they’ve broken the buck,” said Ajay Rajadhyaksha, head of fixed-income strategy at Barclays Capital Inc. in New York. “That unfortunately can spiral in the sense that it makes it more difficult for all companies to raise short-term money because the money-market funds tend to be buyers of short term debt.”

The cost of protecting against a default by Wall Street firms Morgan Stanley, Goldman Sachs, Wachovia Corp. and Citigroup Inc. approached or surpassed record highs reached yesterday, trading in credit default swaps shows.

The Treasury’s $31 billion sale of four-week bills yesterday drew a high discount rate of 0.3 percent, the lowest in the four-week auction’s history.

Gold Gains

In another sign of risk aversion, yields on emerging-market bonds soared as investors moved money into Treasuries. The yield on Russia’s 7.5 percent dollar bonds due in 2030 jumped to a four-year high of 7.12 percent, according to JPMorgan Chase & Co. data. Yields on Venezuela’s 9.25 percent bonds due in 2027 surged to 13.3 percent, the highest since May 2003.

Investors also sought safety in gold as stocks tumbled, driving the Standard & Poor’s 500 Index down 4.7 percent to its lowest level in more than three years. Gold futures for December delivery gained 9 percent, the biggest surge since 1999, to $850.50 an ounce.

Treasuries had declined earlier as the Fed’s bailout of AIG allayed concern that a collapse of the insurer would destabilize the financial system. Barclays Plc, the U.K.’s third-biggest bank, will acquire Lehman’s North American investment-banking business for $1.75 billion, three days after abandoning plans to buy the entire firm.

The Fed will loan up to $85 billion to AIG, the biggest U.S. insurer by assets, in exchange for control. The central bank this week also widened the collateral it accepts for loans to securities firms and boosted its program for lending Treasuries to bond dealers to $200 billion.

Fed policy makers left the target lending rate unchanged at 2 percent yesterday.

“They’ve done everything they can to try to bring a sense of normalcy to the market,” said Theodore Ake, head of Treasury trading in New York at primary dealer Mizuho Securities USA Inc. “Once that normalcy occurs the economy can grow.”

Bloomberg.com