Everyone also knows that some of the key culprits behind this financial mess were the credit-rating firms like Standard & Poor’s and Moody’s Investors Service, which assigned top-tier “AAA” ratings to investments that were actually backed by subprime mortgages and other toxic debt.

Whether it was collusion or incompetence almost didn’t matter: The firms claimed that the credit ratings they issued were constitutionally protected free speech. With this First Amendment shield, S&P, Moody’s and others said they were protected from lawsuits or other liabilities.

But that’s about to change.

A federal court judge in New York last week stripped the ratings firms of that defense, a decision that could expose the companies to billions of dollars worth of liabilities from investors who were burned by the faulty ratings.

Let’s legal case involved three specific firms – two firms that rated collateralized debt securities, and an investment bank that sold the debt. Those three companies were:

• Standard & Poor’s, which is owned by The McGraw-Hill Cos. Inc. (NYSE: MHP).
• The Moody’s Investor’s Service unit of Moody’s Corp. (NYSE: MCO), which is 19% owned by Warren Buffett’s Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B).
• And Morgan Stanley (NYSE: MS).

This particular case had been brought against Moody’s and S&P by Abu Dhabi Commercial Bank PJSC and Washington State’s King County. The case involved losses suffered from an investment in a structured investment vehicle (SIV) called Cheyne Finance. Although the debt securities Cheyne issued were backed in part by subprime mortgages, they received ratings as high as “AAA.”

In return for the high rating, the companies received higher-than-normal fees.

The $5.86 billion Cheyne Finance SIV went bankrupt in August 2007. The plaintiffs claimed fraud. The suit is seeking class-action status on behalf of investors who were burned when Cheyne was forced to dump securities it had issued between October 2004 and October 2007.

Since lawyers for the plaintiffs say the ruling could be applied to any deal involving SIVs, it could have a substantive impact. Before the financial crisis caused the value of these asset pools to plummet, experts estimate there were $350 billion to $400 billion worth of SIVs in existence.

“There certainly will be other cases filed – that’s the future impact of this decision,” San Diego attorney Patrick Daniels told The Wall Street Journal.

Moody’s and S&P had sought a dismissal, citing their First Amendment protections. But U.S. District Court Judge Shira Scheindlin ruled on Sept. 2 that securities ratings that were distributed to a small group of investors don’t warrant the same First Amendment protections that are afforded to the widely circulated ratings of corporate bonds.

Judge Scheindlin acknowledged that ratings constituting “matters of public concern” are typically protected from liability. That’s especially true when the ratings are distributed to the general public. But it wasn’t the case here.

“Where a ratings agency has disseminated their ratings to a select group of investors rather than to the public at large, the ratings agency is not afforded the same protection,” Judge Scheindlin ruled.

The ruling will likely be appealed. And it could end up in front of the U.S. Supreme Court.

The case spotlights the biggest problem with the business of rating securities: The ratings firms are paid by the issuers to rate them.

When you get right down to it, ratings firms are in business not to rate but to make money for themselves by rating issuers and their securities. The surprise isn’t that the obvious lack of objectivity fostered abuses in the credit-rating process – it’s that the problem took so long to come to a head. The complexity of mortgage-backed securities (MBS), collateralized mortgage obligations (CMOs) and collateralized debt obligations (CDOs) only exacerbated the investor risk.

The decision received widespread media attention. But it’s only half the story.

And the media missed the other half.

In an ironic twist that transforms the credit-rating firms into legal sacrificial lambs, the U.S. Securities and Exchange Commission (SEC) has in recent weeks acknowledged its own failure to protect the public from the same ratings firms that the federal agency mandates that investors rely upon.

This admission – combined with the legal assault on the constitutional protections ratings firms are used to hiding behind – could threaten the ratings firms’ very existence. It not only will further fuel investor ire, it could also provide litigants with additional needed legal ammunition. The ratings involve tens of billions – if not hundreds of billions – of dollars of failed securities.

A series of internal reviews by the SEC – one reaching back to last year – has highlighted some of the abuses.

About a year ago – in July 2008, to be exact – the SEC concluded a 10-month examination of the ratings industry that uncovered “poor disclosure practices and procedures guiding the analysis of mortgage-related debt and insufficient attention paid to managing conflicts of interest.”

According to the report, there was an obvious degree of knowledge and complicity in playing the ratings game.

E-mail exchanges between analysts at “unnamed” ratings firms back this up. In one, an analyst said the firm’s ratings model didn’t capture “half” of the deal’s risk, but said that the security “could be structured by cows and we would rate it.” In a Dec. 15, 2006 missive, a manager wrote that the ratings industry was creating “[an] even bigger monster – the CDO market.”

Confided the manager: “Let’s hope we are all wealthy and retired by the time this house of cards falters.”

In July of this year, in testimony to Congress, SEC Chairwoman Mary Shapiro said she supported proposals to impose liability standards that would make it easier for investors to sue credit ratings firms. That’s a bit ironic given that the SEC is charged with supervising the ratings firms.

According to the internal investigation conducted by the Office of Inspector General, the SEC failed to exercise its duties as the nation’s watchdog of the same credit ratings firms that many large investors are forced to trust.

By law, certain investors must rely on the ratings of a handful of companies, known as  “Nationally Recognized Statistical Rating Organizations,” or NRSROs. In many cases, the NRSROs determine what are “eligible” or “appropriate” investments. And it’s the SEC that determines who is, or who can be, an NRSRO.

For instance, most state insurance regulators say that insurance companies can only invest in assets that carry one of the top four credit ratings. And it’s the NRSROs that certify those ratings.

Similarly, money-market funds can only invest in the highest NRSRO-rated securities.

Countless institutions – public and private, domestic and international – rely on rules that determine what assets are acceptable investments. And that acceptability is determined by financial due diligence and the resulting credit ratings – as determined by SEC-certified rating agencies.

It’s not clear that any of this is really protecting investors, according to a Feb. 15, 2008 “Review & Outlook” piece in The Journal. Drexel University Finance Prof. Joseph Mason took a look at CDOs that were “Baa” (an investment grade rating) by Moody’s. His finding: They were 10 times more likely to default than equivalently rated corporate bonds.

In that same article, an S&P spokesperson was asked if they actually examined the mortgage debt that made up the investment pools that make up a CDO.

The spokesperson’s answer was not confidence-inspiring: “We are not auditors; we are not accounting firms.”

Source: The Credit Rating Firms Are Running Scared – It’s About Time

There are a lot of uncertainties permeating the market right now, not the least of which is healthcare reform. Will that reform entail a public option that could add $1 trillion to the deficit?  How is reform going to be financed?  And is it going to mean higher costs for employers across the board, or just the healthcare insurers?

Investing is made infinitely more difficult when 18% of U.S. gross domestic product (GDP) is hanging in the balance.

And you still have to consider:

• That unemployment is likely to keep rising, perhaps over 10%.
• That the U.S. Federal Reserve’s policy of quantitative easing is slowing down.
• That there is almost certainly a second wave of home foreclosures on top of the current commercial real estate epidemic.
• And that retail sales are still a long way from recovery.

There is also reason to believe that the U.S. dollar will continue to be weak, though it probably won’t sell off precipitously.

The U.S. dollar has weekend against the Euro lately, having fallen 0.8% Friday.  Technically speaking the chart shows a traditional “cup and handle” formation that could lead to an acceleration of the dollar’s downward trend.  Gold prices, up about 13% Friday, confirm this trend and could soon break through the $1000/oz resistance.

Fundamentally, if the economy – encumbered by high unemployment and a relapse of the housing market – does not pick up the dollar could be further imperiled.

Weakness in the dollar will also be affected by the Fed’s withdrawal of liquidity, which is likely to proceed at a gradual pace.

Finally, diversification away from the dollar among the world’s central banks is taking place, albeit at a slower pace than many analysts have suggested, and that too, is weakening the dollar.

Let’s concede that there is no currency that could supplant the dollar as the world’s major reserve currency. So, it’s unlikely that the world’s central banks will simply abandon the dollar anytime soon. However, we must also acknowledge that a reduction in the weightings of the U.S. dollar within central bank reserves is already underway.

An Aug. 14 article by BNP Paribas currency strategist Ian Stannard in Euromoney recently described this gradual shift in currency reserves.  The article noted that only 62.5% of global currency reserves are in U.S. dollars, down from about 66% in 2005.

So I do not anticipate a sudden shift in central bank reserves, but rather a continuation of the measured restructuring we’ve seen so far. Thus, the slow weakening trend in the U.S. dollar is likely to continue.

So, in this very uncertain investment scenario, I prefer to go for more secure returns in bonds.  And we can achieve great diversification at a cheap cost with the iShares iBoxx $ Investment Grade Corporate Bond Fund (NYSE: LQD).

For starters, its weighted average coupon of 6.26% offers a current yield slightly north of 6% at today’s prices.  Investors are assuming interest rate risk, which means that if interest rates climb, the value of the bond has to come down.  But in the short term, there is no immediate threat of inflation.

Looking at the major holdings of the fund – which has no single position that accounts for more than 1.26% of its total holdings – I see some names that have demonstrated continued stability and others that have shown recent signs of improvement, such as American Express Co. (NYSE: AXP).  So I do not expect any major credit spread hiccup here.  I certainly do not see any hiccup that a 6.26% coupon would not compensate for.

For an additional hedge against dollar weakness, I suggest you revisit my June 8 recommendation of the iShares SPDR Gold Trust ETF (NYSE: GLD). You may also consider buying a bit of the PowerShares DB US Dollar Index Bearish (NYSE: UDN) fund.  Do not go overboard. Err on being light, rather than heavy on hedging, since timing currency moves is very difficult.

Recommendation: buy iShares iBoxx $ Investment Grade Corporate Bond Fund (NYSE: LQD) at market.  Consider hedging part of the US dollar risk by buying the iShares SPDR Gold Trust ETF (NYSE: GLD) and PowerShares DB US Dollar Index Bearish (NYSE: UDN). Both funds should account for a fraction of your position.  Have a 5% stop loss on UDN (**).

Source: Buy, Sell or Hold: The iShares iBoxx $ Investment Grade Corporate Bond Fund

But in fact, foreigners have, over the last decade, been by far the single most important source of buying for U.S. Treasuries.

Given the Treasury’s need to flog on the order of $3 trillion worth of its unbacked paper this year just to keep the government’s doors open – and that is a four- or fivefold increase over 2008 – the foreign buyers not only have to show up for the Treasury auctions, they have to show up in droves.

In mid-July, the Associated Press reported that “Foreign demand for long-term U.S. financial assets dropped by the largest amount in four months in May, as Japan and Russia trimmed their holdings of Treasury securities … foreigners actually sold $19.8 billion more long-term U.S. securities than they purchased in May. That compared with net purchases of $11.5 billion in April.”

Below you see the big picture of all cross-border flows in May as published by the U.S. Treasury. It shows both foreign investment in the U.S. and U.S. investment abroad. It includes Treasuries, agencies, corporate bonds, equities, and short-term instruments like T-bills. Foreigners bought a lot of T-bills when the credit crisis became acute.

This should be a serious situation with a big drop in foreign investible funds for meeting U.S. borrowing needs. The borrowing by households and business has dropped close to zero, decreasing demand, while government borrowing has jumped but is still smaller than the private borrowing drop. The Fed has added some lending.

A look at just the longer-term Securities (not T-bills) is even more convincing of the slowing of lending by foreigners:

This decrease in credit should pressure rates higher.

And here is the breakdown of foreign investment into the U.S. Foreigners only continued to buy Treasuries, shunning new investment and selling off agencies in the riskier real estate market.

It’s not for nothing that the Goldman Sachs Secretary of the Treasury Timothy Geithner is hotfooting it around the world lately, last week to Saudi Arabia and the UAE… last month to China.

The purpose of his trip, Geithner told reporters in Paris, he was doing this tour ”to make sure we keep working with governments around the world to continue to provide enough support to lift this global economy back to a sustained pattern of growth.”

Translation: Look here, we’re all in this together. If you jump ship now, we’re all doomed… DOOMED, I say!

But the fact remains that the foreign holders of U.S. dollars have it within their ability – either deliberately or inadvertently as the result of a panic setting in – to literally destroy the U.S. currency.

The latest report shows Russia and longtime monetary ally Japan edging toward the door. China and the oil-exporting nations continue to convert an increasingly moderate amount of their trade surplus into Treasury bills – but not on a nearly large enough scale to meet the inflated (and inflating) borrowing needs of the utterly bankrupt U.S. government. And how long will they continue to show up, when an increasing number of other foreign buyers start selling their Treasuries? No one likes to be the last one to leave a party, especially when the bananas flambé has tipped over on the floor and the curtains are on fire.

Put simply, the only thing now standing between the U.S. dollar holding its own and an almost overnight debasement (and history has shown us that when things go wrong with a currency, they can go wrong very quickly) is the willingness of foreigners to play nice. This was never a threat that the Japanese had to deal with during the worst of their recent dark days, but it’s a very real risk here and now in the United States.

That that risk sits on top of the monetary inflation that has been the steady response of the U.S. government so far –  and will continue to be its response as the economy further erodes – is not something to be sniffed at.

On July 17, Bloomberg reported that “China’s finance ministry failed to meet its debt-sale target for a third time in two weeks at a 182-day bill sale, according to traders at Galaxy Securities Co. and China Citic Bank in Beijing. The ministry had tried to sell 20 billion yuan of bills and only sold 18.51 billion yuan, traders said. The average yield for the bills sold was 1.6011 percent, they said.”

Here’s our take on this news item: The problem from the Chinese government’s point of view is that they were not able to borrow as much money as they wanted, in the light that they are now spending at a very fast clip with a big stimulus program to keep their own economy (bubble?) growing. So how can they fund the spending? They can sell off the stash of foreign-currency-denominated holdings they are sitting on. That could mean Treasuries dumped on the world market.

There are other alternatives, like getting the People’s Bank of China to print up some new money for the government, which would inflate the renminbi (RMB) and decrease its international price and attractiveness. They might like to let the RMB fall to encourage exports and keep relative worker pay low on the world competitive scene. But they are also trying to make the RMB a world currency by itself, so they don’t want it to look weak and at risk.

Our guess is that they are selling Treasuries and not telling.

[Note: In latest news this week, Chinese Prime Minister Wen Jiabao said China “will use its foreign exchange reserves to support and accelerate overseas expansions and acquisitions by Chinese companies.” Jiabao called it China’s “going out” strategy. Going out (with a bang), though, may be a better description of what the U.S. will ultimately do.]

This is what The Casey Report, Casey Research’s flagship publication, does: spotting budding trends in the economy and the markets, and then devising ways to profit from them. A strategy that – as thousands of happy subscribers can vouch for – is paying off… and paying off big. Right now, one of our favorite plays, and surest bets, on the economic quagmire we’re in is an investment that is almost guaranteed to be a winner. Let Casey Chief Economist Bud Conrad tell you all about it in his free report. Click here to learn more.

Source: Foreign Investment in the U.S. – Going Down, Down, Down

This from an email Ron sent Dan on Tuesday after the market closed (hat tip, The S&A Digest ):

Source: Another Dismal Earnings Season for U.S. Companies?

But what if I told you that you can make two to three times the long term stock market average (15% to 30% annual returns)… without taking stock market risk?

Considering the return of the stock market the last couple of years and the fundamentals going forward, I hope you’ll give this your consideration. So how do you beat the market, without putting your money at risk in Wall Street’s casino? Corporate bonds.

Most investors avoid bonds because they think they are boring and the returns are too low. Or they simply don’t understand how they work. This is a big mistake.

Today, I’ll show you how to use high quality corporate bonds (no junk) to generate 15% to 30% annual returns (and more). And I’ll also show you a simple way to determine exactly how much you’ll make when you invest in a bond.

So forget what you have heard about “boring” bonds. I can show you how to build a high octane portfolio, but without the risk and volatility associated with the stock market.

When you invest in a stock, you own a small percentage of the company. But the company makes no promises whatsoever. You have no idea what the price of the stock will be next month or next year. And if the company pays a dividend, there is no guarantee that it will go up in the future or that it will even continue. In terms of financial obligations, shareholders come in just about dead last.

Bondholders are in a more privileged position. When you buy a bond, you have agreed to loan the company your money. For its part, the company is legally bound to return the face value of the bond, plus interest. In other words, you will know (before you invest) exactly what you’re going to be paid.

The only thing that can disrupt your investment is if the company breaks the contract and defaults on the loan. Even in this case, bondholders usually collect something. Often, they receive 100% of what is due, even in bankruptcy. Stockholders, on the other hand, are normally wiped out in bankruptcy.

Now consider that the long term default rate for the most speculative bonds (so called “junk bonds”) is just 4.5%. That means that 95.5% of speculative bond issuers pay exactly what they owe and right on schedule. According to Moody’s, the default rate for investment grade bonds is even slimmer. On a long-term basis more than 99% of these issuers fulfill their obligations to investors.

Think about this for a moment… How would YOUR portfolio look if 99% of your investments made you money? Where would you be today if you made 10% per year on every investment you ever purchased? I expect retirement would be a lot closer… or a lot more comfortable if that were the case.

Now let me show you how to calculate your return on a corporate bond and how to beat the market, hands down, with a far greater level of safety…

If you were to ask an academic how to calculate your return on a bond, they might give you the following formula to calculate yield to maturity:

If you understand that, you can stop reading now. Otherwise, here is a much simpler way to determine your return.

Subtract what you paid for the bond from its face value. The difference is the capital gain you will receive at maturity.
Add the capital gain to the total expected interest payments.

Divide the sum (interest payments + capital gain) by the amount you paid for the bond. This is your “Total Return”
Divide the total return by the number of months to maturity, then multiply by 12. This is your “Annual Return”

Now let me give you an example, using a bond that my colleague Steve McDonald recommended to his subscribers in April.

The bond is issued by Sallie Mae. It matures in October of 2011 and has a coupon of 5.4%. Since corporate bonds are issued with a face value of $1,000, the 5.4% coupon equates to $54 per year in interest.

But Steve’s subscribers didn’t pay face value for the bond. They bought it at a discount and paid just $660. So let’s calculate what this bond will return.

$1,000 – $660 = $340 (capital gain)
5 interest payments x $27 = $135 + $340 = $475 (capital gain + interest)
475 / 660 = 71.96% Total Return
71.96 / 28 x 12 = 30.84% Annual Return

So in this example, we have a safe, investment grade bond that will return 31% annually. That’s more than three times the average long-term return of the stock market. And this is an investment with a contractually bound return. The only way Steve’s subscribers would not receive this return is if this government-sponsored enterprise (GSE) defaults on their obligation in the next two years. According to Moody’s and S&P, which have both rated this bond “investment grade”, this is highly unlikely.

The key to making high returns consistently in corporate bonds is to buy the safest bonds you can find at the biggest discount. That way you can add a significant capital gain to your regular interest payments. Steve issues recommendations like this every week to subscribers of his service, The Bond Trader.

Since September, 59 out of 62 of his recommendations have increased in value, two are essentially even, and only one recommendation has lost value slightly. I’m guessing you would sleep a lot better if nearly 100% of your investments had increased in value over the past year… along with paying you regular income.

If that sounds interesting, consider adding corporate bonds to your investment portfolio. In fact, it’s likely you are under-allocated to bonds anyway.

The simplest rule of thumb is to use your age to determine your allocation between bonds and stocks. If you are 60 years old, you should have 60% in bonds and 40% in stocks. If you are 30, you should have only 30% in bonds, with 70% of your portfolio allocated to stocks.

“Letting it ride” might be an entertaining experiment when you’re up $300 at the craps table in Vegas, but the concept has no place in your retirement plan.  The older you get, the more assets you should move to the safety of bonds.

Not only will you sleep better at night, but if you follow the right strategy, you’re likely to trounce the returns that most investors make in stocks.

To your success,

Jon Herring

Source: Make Stock Market Returns -Without Stock Market Risk!-

The thing that bothers us most is the supposed solution to the problem – more easy money – is also the intrinsic cause. Governments around the world want to “reinflate” the economy. But we know there’s a fine line between “reinflation” and “inflation.” Hence our uneasy sleep.

Will’s father, Bill, has made a quick tally of the funny money entering the system. “The US Federal Reserve,” he writes in The Daily Reckoning, “has been authorized to “print” $1.75 trillion worth of new money in order to buy Treasury bonds. The Bank of England has its own program – worth £75 billion, so far. Even Switzerland has been printing money – so much that its money supply, as measured by M2, is growing at 30% per year. And two weeks ago, the European Central Bank announced that it too would begin creating money in order to buy corporate bonds.”

The question, of course, is where does this money go after it is born? And what effect does it have on the economy?

We like to call all this newly printed money “Abracadabra money.” Bill is more direct. He calls it “counterfeit money.” But whatever you call it, determining where it will end up and what kind of trouble it will cause is never straightforward. It seems like Bill is having nightmares too.

We thought the Bubble Epoch was the peak in claptrap and illusions. But we were only in the foothills. The feds now pretend to bail out the economy by giving money to companies that pretend to be concerned, run by people who pretend to know what they are doing. And when they run short of money, they create more of it, pretend it is real… and pretend they can tell it what to do.

What is likely is that money will have a mind of its own. First, the markets will react…and the authorities will not. They will remember their own critiques of Japanese and Roosevelt-era monetary policy. In both cases, they believe central banks removed the punch bowl too early – before the party really got rolling. In both cases, the recovery was cut off.

Then, while they are hesitating, money will turn on them. Inflation rates will rise further. The velocity of money will pick up. And investors – including foreign governments – will become eager sellers of government debt. Suddenly, it will be too late. In order to remove the monetary inflation they previously added, central banks will have to sell bonds, instead of buying them, trying to reabsorb money from the economy. The extra cash will then disappear back into the central banks. But in order to bring inflation under control, the biggest bond buyers in the world must turn into the world’s biggest sellers. Bond prices, already falling as investors fear the worst, will collapse immediately. An avalanche of dollars will fall upon the world markets – as dollar holders all over the world become desperate to get rid of them.

We don’t know what day it will happen. But we have a good idea as to what time of day central bankers will realize that they are doomed. About 4am is our guess. That is the moment when Ben Bernanke and other central bankers begin to feel like members of the Donner Party.

Here’s a company that will require a little risk taking but can give you a return well above the long term stock market average of 10% a year, in fact 34% a year, and you can do it in a bond not a stock. That means you will know exactly what you will make, to the penny, before you invest.  In my experience, this requires a lot less risk than the
average stock investment.

The story goes like this.

A group of very savvy bankers got together and found a way to make money on airliners; 777’s, Airbuses, etc. They buy the airliners from the manufacturers, Boeing (NYSE:BA), Airbus, and then lease them to airlines all over the world, not just the rude, inefficient ones here in the U.S. That’s not fair, Southwest isn’t rude or inefficient.

The bankers make their money on the spread between what their loans cost them to buy the airplane and what the airlines pay to lease them. These are very long leases and have been very profitable for the bankers.

The planes are leased to the best airlines in the world and they make up most of the newer planes in their fleets. The planes you hear about that are being retired for cutbacks are not the leased airplanes. They are the older less efficient models.

The airlines love this arrangement because it takes all kinds of debt issues off their hands and they have a known cost going forward for an airplane. Maintenance and repairs are their problem, but their balance sheets are not loaded up with billions of dollars of depreciating aircraft that will eventually be worthless.

The bankers love it because they make a ton of money for basically pushing paper, which is what bankers do best. Sounds like a win-win, doesn’t it?

Here comes the risk part. This company that leases airplanes is owned by AIG. Yuck!

Wait, this is the only profitable division of AIG and lots of people want to buy it. There was a five billion dollar buyout offer this past weekend. But it’s still owned by AIG, right?

This is where you have to be willing to bet on the winning portion of AIG and take a little risk. Consider this strategy.

There is a very short maturity bond from the company, which is called International Leasing, which will give a great current yield for a few years, 8.51% and a very nice capital gain, 54.8%.

The short maturity limits our market risk because we aren’t marrying this one for 20 years or more, less than four years. It also carries an investment grade rating of BBB+, which gives us a lot of credit quality to bank on.

Here is the actual bond;

International Leasing, BBB+, cusip 45974va73, coupon 5.5%, cost 64.6, or $646, maturity 9/5/12, or about 40 months. The current yield is 8.51% (5.5/646) and a total return of 114% (capital gains $354 and seven interest payments of $55 divided by your cost of $646). That’s an annual return of 34%.

34% a year from an investment grade bond! You have got to be kidding me!

Yeah but, what if AIG goes under? That’s where the fact that International Leasing is one of the only profitable divisions, if not the only profitable part of AIG, comes in.

There are lots of people who want this company. If anything I believe AIG will milk it for a big sale price or continue to run it for the revenues. It’s a cash flow cow.

A very profitable company that many people want to own that happens to have a bum for a parent. The real question is will International Leasing be in business in 40 months? The answer is yes and this bond will be fine.

As with all investments, limit how much you have in any one bond.

This is exactly the type of strategy I send out every week in the Bond Trader and will be presenting at the Gloom and Boom Conference in Miami June 5, 6 and 7. Click on the link for all the details.

Good luck.

Source: Judging Risk

While we have been getting roughed up to the tune of almost a 50% drop in the stock indices, corporate bonds have been as solid as stone, with a few exceptions.

Right now, you can earn as much as 15-17% per year on investment grade corporate bonds with very short maturities. So why are we taking risks in the stock market and getting killed?

Simple, most people know less about bonds than any other investment. Too many moving parts, too many new terms to understand, so they stay within their comfort zone.

Yield to maturity, current yield, yield to call, mandatory calls, sinking funds, coupon, treasury spreads, accrued interest, it’s enough to drive anyone mad. Just when you thought you had stocks mastered.

Here is an idea that will help get you out of the line of fire of the stock market and into a safer, saner investment that will beat the stock market’s long-term return. I can’t explain it any simpler.

Alcoa has a bond that is really cheap right now. All bonds are offered at $1000 each, or there about, and all mature at $1000, but you can buy them on the secondary market cheaper if the business has a slow down, as Alcoa has.

You can buy this particular bond for about $830, which means you get a capital gain at maturity of $170 in addition to the interest it pays which is 6.5%.

The bond matures in June 1, 2011, that’s a holding time of 27 months. That’s considered an ultra short maturity. On June 1, 2011, you will receive your last interest payment of $32.50 and $1000 at maturity, even though you only paid $830 for the bond.

Here’s how to figure your annual return. Most people really have trouble with this part of bonds.

You will receive interest payments on or about June 1, 2009 and 2010, and on January 1, 2009, 2010, and 2011. That’s five interest payments of $32.50 (half of 6.5% annually or $65.00/2).

You get $162.50 in interest and capital gains of $170 at maturity, for a total of $332.50 for an $830 investment.

You have something called accrued interest, which deducts about $10 from your total. Don’t ask, it’s one of those bond things that I don’t have time to explain, which leaves you with $322.50.

You divide your total of $322.50 by your purchase price of $830. Your total return for a 27-month hold is 38.85%.

To get your annual return divide your total return, 38.85% by 27, the number of months you held it, for .014, and multiply that by 12, because there are twelve months in a year, or 17.2% per year.

Alcoa is an investment grade bond, not a junk bond. Investment grade bonds, according to Moody’s records, have a 99% success ratio for an 80-year period. That means they pay off 99% of the time.

Many investment grade bonds will pay you this much per year and more. The question you should be asking yourself is, “why am I getting killed in the stock market when I could be doing this?”

A return of 15% per year and a 99% success ratio for an 80-year period. Think about it and take a look at the Bond Trader. We do this every week.

Source: A Safe 15% Per Year, No Sweat

Here he explains how the recently signed U.S.  government bailout “will make corporate bonds the place to be for a very long time.”

As the stimulus and banking packages unfold, there is one thing that we know for certain, there will be one hell of a lot of money printed and pumped into the system. The success, or degree of success of these programs is still up in the air, but we know for certain that we will have a lot of new money out there.

These bailouts will result in a series of events that will make corporate bonds the place to be for a very long time. In fact, bonds may be the only place you will make money in the next few years.

The first event is already in progress, printing lots of new money to finance the bailouts. Let’s ignore the cost of financing these bailouts and just look at the effect it will have on inflation.

Unavoidably, inflation will be primed to take off.  It’s like pouring gasoline on a fire. You pour enough money on the economy and the flames will get bigger. This is the second event.

As we all know, too much inflation is death for our economy and the stock market. It’s like not being able to get your in-laws to go home. Life is awful. You have to have lived through the late ’70s and early ’80s to appreciate this fact.

Are double-digit interest rates like the early eighties possible? Considering the amount of new money being pumped into the economy, it is more likely than most can imagine right now.

The third event, the Fed will have to raise interest rates to control inflation or hopefully stop it before it can do its damage to the economy and the stock market.

Look back to 1994 and see what multiple interest rate increases did to the stock market in a normal economic environment. The average stock was down at least 30%. I can’t imagine what will happen in the already challenged economic environment we have now.

The fourth event will be for bond prices to drop as the Fed increases rates. How the Fed’s actions affect bond prices is not a complex relationship, but it would require too much space for me to explain here, so you’ll have to take my word for it.

These interest rate increases will create one of the best buying opportunities in bond history. Using a simple strategy, you will be in a position to buy up discounted bonds at higher current yields than they were paying last year.

Discounted bonds not only pay you a higher current yield than the coupon of a bond, it also pays you capital gains at maturity. In the past six months, I have taken capital gains on these same types of bonds as high as 97% in less than two months.

If you are a person that buys long maturity bonds to get the highest interest rate you can, you may want to pay particular attention to the rest of this article. Long maturity bonds will be crushed in what appears to be all but a guaranteed high interest rate, high inflation environment.

Here is a simple and safe method for beating the market for the next five years. Invest in ultra short term, investment grade corporate bonds on an averaged and staggered basis. Here are the particulars.

Investment grade only. Junk bonds have earned their name. Does this mean you can never have a BB bond, investment grade are BBB to AAA, no. There are some exceptions, but staying in investment grade bonds gives you an 80-year documented success ratio of 99%. That means 99% of the time investment grade bonds pay off. Junk bond payouts are significantly lower.

No matter what is happening in the economy, quality is always your safest bet in investments.

Short term, staggered maturities of three years or less. This is the key to the success of this approach. It will sound very foreign to most bond investors, but give it a chance.

Long maturity bond prices are crushed by interest rate increases. Short maturity bonds, in this strategy that means six months to three years, will drop in price but much less. Since they mature sooner they also allow you to buy back into a rising interest rate market and take advantage of the price drops.

In long bonds, you’re stuck. The ultra short maturities give you as much protection as possible from getting stuck in bonds that you will have to take a loss on to get out of in the coming inflation.

There are two more techniques you need to use to add a little more security to this method: staggering and averaging in.

Staggering your maturities will give you an extra edge. It’s accomplished by buying into the market in small amounts, five or ten bonds at a time and plan on having 10 to 25 different bond positions added to your portfolio over a 12 to 18 month period.

This does two things. It averages you into a market over time, which will typically give you a better average cost, and it staggers your maturities so you will have several bonds coming due every year. This gives you fresh money to reinvest as bond yields go up and prices come down with the rate increases. Staggering and averaging in will also give you better diversification, which is always a good thing.

No matter what you choose to do, never load up on a few bonds because the coupons look to be good at the time. This is the oldest trap in the money business for conservative investors. It will end up costing you.

Don’t let your lack of familiarity with bonds keep you from using this technique. Take a look at the Bond Trader, it does everything I have described here and uses a few additional techniques to give its investors the long-term returns of the stock market without stock market risk. To date it has not had a single loss.

Source: How the Stimulus Will Drive Bond Profits To New Highs