U.S. Debt Ceiling Fears Prompt Nervous Investors to Flee Mutual Funds

Investors nervous about the prospect of a default by the U.S. government pulled money out of all forms of mutual funds, from money-market funds to those that invest in stocks.

U.S. money-market funds experienced $103 billion in redemptions the week ended Aug. 2, the most in one week since the bankruptcy of Lehman Brothers Holdings Inc. in September 2008, according to iMoneyNet, a fund research firm in Westborough, Massachusetts.

Mutual funds that invest in stocks and bonds had net redemptions of $10.4 billion in the week ended July 27, according to an e-mailed statement from the Investment Company Institute, a Washington-based trade group. It was the biggest withdrawal since the week ended May 26, 2010, when investors pulled $17.4 billion, ICI data show.

“We saw people get nervous in May during the Greek debt crisis and this situation hit much closer to home,” Russel Kinnel, director of mutual fund research at Chicago-based Morningstar Inc. (MORN), said in a telephone interview.

After weeks of failed negotiations, U.S. congressional leaders and the White House agreed to raise the U.S. debt ceiling yesterday, the same day the Treasury Department said the government would run out of money. Republicans had refused to back the measure until Democrats agreed to a long-term deficit- reduction plan. U.S. debt still faces a potential downgrade by ratings firms.

U.S. Equity Funds

Money funds lost more only once before, when investors pulled $121 billion in the week ended Sept. 23, 2008. Lehman declared bankruptcy on Sept. 15, 2008, and the $62.5 billion Reserve Primary Fund, which held Lehman debt, closed the following day, triggering a run on money funds eligible to buy corporate debt, known as prime funds.

Institutional prime funds lost $61 billion and institutional government funds had $47 billion in withdrawals last week, according to iMoneyNet. Retail government funds lost $1 billion, while retail prime funds attracted $6 billion in deposits.

Funds that invest in U.S. stocks suffered $8.8 billion in redemptions last week, the most among stock and bond funds. Such funds had $9 billion in withdrawals in the first six months of 2011, ICI data show, which puts them on pace for a record fifth- straight year of redemptions.

Investors withdrew $1.34 billion from funds that buy international stocks, $67 million from taxable bond funds and $147 million from municipal bond funds, ICI data show.

Downgrade Risk Remains

Moody’s Investors Service, which found the deficit- reduction deal insufficient, put the U.S. on notice that it is at risk of a downgrade without additional deficit reduction measures. While the New York-based firm retained its AAA rating on U.S. debt, the outlook is now negative.

The most recent data on the U.S. economy has raised concerns about a slowdown and possibly a recession.

Gross domestic product expanded at a 1.3 percent annual rate in the second quarter, after a 0.4 percent pace in the prior period, the worst six months since the recovery began in June 2009, according to Commerce Department figures released July 29.

“There’s now a 50 percent chance that we could slide into a new recession,” Martin Feldstein, a Harvard University economics professor, said yesterday in an interview on Bloomberg Television’s “Surveillance Midday” with Tom Keene.

To contact the reporters on this story: Charles Stein in Boston at cstein4@bloomberg.net; Christopher Condon in Boston at ccondon4@bloomberg.net

To contact the editor responsible for this story: Christian Baumgaertel at cbaumgaertel@bloomberg.net

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