- Published on Wednesday, 06 June 2012 08:00
- Written by Andrew Snyder, Editorial Director, Inside Investing Daily
- Hits: 730
You've probably never heard of them... and there's little chance you own any... but covered bonds are about to explode in a big way.
In a time of huge uncertainty, one thing is clear. If you buy Treasury debt today... you will lose money.
If you hold the debt to maturity you will get hammered by inflation. And if you try to unload your safety net when times are better... you'll have to slip a mighty big discount on your asking price to entice buyers to take such a paltry coupon.
But what if there was an alternative?
What if there was an unconventional asset with the same triple-A rating... and a stronger yield?
If you're an American investor, there's a good chance you've never heard of covered bonds. That means there's an even better chance you don't own any of this ultra-safe debt.
If the dopes in Washington get their butts in gear, though, that may change very soon.
Covered bonds aren't some newfangled creation of Wall Street. Just the opposite. They were invented by Frederick the Great -- the famous 18th-century general who ruled postwar Prussia. They've been at the heart of the European economy ever since.
But somehow... the SEC has never been a fan of covered bonds (more on that story in a minute).
Mechanically, these alternative bonds are simple.
Unlike a conventional bond, which is little more than a high-class promise, covered bonds are backed by mortgages.
In other words, with a typical corporate or municipal bond, the risk of failure is very real. Without collateral to back the IOU, defaults are common.
But that's not the case with covered bonds -- hence their standard triple-A rating.
Like I said, these unconventional bonds are almost always backed by a pool of mortgages. And most important... those mortgages remain on the issuing bank's balance sheet.
Unlike the mortgage-securitization mess that ignited the 2008 blowup, the collateral backing covered bonds can't be bundled and sold.
That's the key.
But that's also why Americans are pretty much out of luck when it comes to ultra-safe Treasury alternatives. Uncle Sam's regulators have been too busy chasing their tails to figure out how covered bonds could work in the States.
In the two dozen or so countries where covered bonds have been successful, there are very specific rules that spell out how collateral is divided when an issuer fails.
But in the States... there are no rules. The FDIC has no clue how to treat covered bonds in case a bank fails. Thanks to boondoggles like TARP, Europe's straightforward rules won't work.
And it's costing you money.
As I write, for example, a five-year Treasury note comes with a rate of just 0.684%.
Phooey... that's lousy.
The pain of that anemic return is amplified when we look at similar triple-A-rated covered bonds. If we buy one from the Bank of Nova Scotia, we'll get paid 1.33%. Or if we look to Barclays, we'll get a return of 2.21%.
That's triple the return... with almost no increase in risk.
Again, these are virtually fail-safe bonds with the same label as Uncle Sam's "risk free" debt. Not only is the debt backed by the issuing bank, but it also has very real collateral set aside specifically to guarantee the investor's principal. Even the Treasury can't make that claim.
For over 200 years, covered bonds have been considered one of the safest investments on the market... which begs a question.
Why in the world hasn't Washington embraced the bonds?
In a word... competition. If Americans have more access to über-safe debt, we won't be there to prop up our national spending spree.
In other words, if the playing field were level, Uncle Sam would have to pay a bunch more than the current 0.68% rate.
But mark my words. We are about to see a boom in covered bonds here in the States. Thanks to the European meltdown, the pressure is too great to hold back.
In fact, just in the past few weeks, the SEC cracked the floodgates. After 18 months of bickering, it gave the Royal Bank of Canada permission to unload $12 billion worth of covered bonds in America under the guise of "registered securities" -- a plan that opens the market, but restricts the sale of bonds between individual investors.
It's true that covered bonds aren't perfect -- there's still room to play tricks with the collateral -- but they offer a sound alternative to a manipulated and deceit-filled Treasury market.
If you want an alternative to the Bernanke bubble... covered bonds are the space to watch. They've finally made it into U.S. territory; now they're about to explode in a big way.
P.S. If you like unconventional assets like covered bonds, you will love my newsletter Unconventional Wealth. Investments like these are the backbone of every monthly issue. In fact, here's a link with details on over two dozen of my favorite alternative assets.
Chart of the Day: Tough Times, Good Opportunities
By Adam English, Associate Editor, Inside Investing Daily
As the global economy slows and concerns grow about the U.S., we are entering another period where good opportunities abound... if you have the stomach it takes to ride this roller coaster.
As a case study, we can just take a look at Joy Global. After the company revised its 2012 estimates downward, shares dropped 5.12%. Joy's shares are down 43% since February.
Joy makes and repairs just about anything you need to extract minerals from the ground. It will sell you crushing equipment, electric shovels and drills... and it will keep them running.
Commodities are suffering across the board. Unfortunately for Joy, the reduced demand for coal in the U.S. and a downturn in the global economy are having an effect on new orders.
In spite of the difficult climate and the beating the company took in the market, Joy's fundamentals are surprisingly strong. The company has pulled in profits in seven of the past eight years.
After the recent 5.12% drop, shares traded at 8.2 times earnings. That is considerably lower than the vast majority of similar mining and construction equipment manufacturers.
Meanwhile, the company is more profitable than its peers. The company brought in 13.6 cents in net income from each dollar of sales in the past 12 months. About 60% of its sales are from maintenance and repairs. That's an important figure because the constant stream of revenue helps to stabilize earnings figures.
The earnings announcement also noted that quarterly revenue was up 45.1% year-over-year. The company expects to post record sales of $5.5 billion to $5.7 billion this year, an increase of as much as 29% from fiscal 2011.
As long as we're going through tough times, commodities and the companies that profit from them are going to suffer. However, investors have incredible opportunities to get ahead of the game if they have the time and stomach to ride it out.
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