Say Goodbye to Safe Assets

The supply of safe assets around the world has decreased markedly since the onset of the financial crisis. Vast swaths of investment-grade securities were wiped off corporate balance sheets in the aftermath of the housing collapse, and now the same thing is happening to sovereign bonds. There's growing concern, for example, that Italy and Spain -- the eighth-and 12th-largest economies in the world -- will either default or be forced to seek an international bailout in the near future.

While the reduction in safe assets has garnered widespread attention among institutional investors, no comprehensive, integrated view of the problem emerged until earlier this month, when the International Monetary Fund released its Global Financial Stability Report (PDF file, Adobe Acrobat required). According to the report, "Considerable upward pressure on the demand for safe assets at a time of declining supply entails sizable risks for global financial stability." In an article earlier this month, I looked at one source of increased demand: higher central bank reserve balances. Below, I look at the primary source of pressure on supply: the degradation of sovereign debt.

Calibrating our perceptions of safety
When most people think about safe assets, they think about shares in blue-chip companies like Procter & Gamble. Since its founding, the company has survived the Civil War, the Panic of 1907, World War I, the Great Depression, World War II, double-digit inflation of the Volcker years, and the Great Recession, among others. And through all of this, it's emerged as one of the most respected and successful companies in the world. It has more than $80 billion in annual sales, 24 billion-dollar-plus brands, and a presence in more than 180 countries.

Yet even shares in a company like Procter & Gamble don't fit the true definition of a safe asset. As fellow Fool Dan Caplinger discussed, for an asset to satisfy this measure, it must be highly liquid and provide full protection against every type of risk, including credit, market, inflation, currency, and/or idiosyncratic risks such as an industry-specific labor strike. Think of Superman without the vulnerability to kryptonite: a truly safe asset is effectively impervious to everything.

Far from generating an immediate return, the purposes of safe assets are much more prudential. They're used by insurance companies like American International Group (NYS: AIG) to store value and aid capital preservation. Banks and financial institutions like JPMorgan Chase (NYS: JPM) and Bank of America (NYS: BAC) rely on them to enhance capital and liquidity buffers. Mortgage REITS like Annaly Capital Management (NYS: NLY) and Chimera Investments (NYS: CIM) use them to post collateral in repurchase agreements and derivatives markets. They serve as benchmarks for the pricing of other securities. And they're a critical component of monetary policy operations.

With this in mind, it probably won't surprise you that only a handful of assets satisfy these requirements. As you can see in the following figure, the largest bloc consists of investment-grade sovereign bonds, followed by agency-backed and investment-grade collateralized debt instruments like CDOs and CMOs. Then comes gold, investment-grade corporate debt, covered bonds, U.S. agency debt, and supranational debt from institutions like the IMF and World Bank. All told, there's an estimated $74 trillion in total outstanding safe assets in the world.


Source: International Monetary Fund, Global Financial Stability Report.

Zeroing in on the problem
For much of the past decade, it was presumed that the debt of developed economies was risk-free. This is why a full $38 trillion, or more than 51%, of the world's total outstanding marketable safe assets is investment-grade sovereign securities -- that is, government bonds.

However, the financial crisis has shown the folly of this presumption. While 68% of advanced economies carried a AAA rating five years ago, the proportion had dropped to 52% by the end of last year, as countries like the United States, France, and Spain all lost their coveted AAA status. And the same trend can be seen in the movement of sovereign bond yields in advanced economies. Prior to 2008, the yields moved in harmony. After 2008, individual countries started peeling away. Greece was the first to depart, followed by Portugal, and then Spain, Italy, and Belgium. All told, $15 trillion in investment-grade sovereign debt has been downgraded.

Why is this happening? Quite simply, countries are far too leveraged. The debt-to-GDP ratio of the euro area went from 66% in 2008 to 85% last year. The United States' went from 64% to 93%. And Japan went from an already-high 188% to an even higher 220%. While the total general government gross debt of advanced economies amounts to more than $47 trillion today -- this includes both investment-grade and non-investment-grade sovereign bonds -- the IMF projects this figure will rise to $58 trillion by 2016, an increase of 38%.

It's important to note, moreover, that things are only getting worse as governments struggle to compensate for a reduction in aggregate demand caused by public and private deleveraging. You could pick almost any Western country and see this in action by looking at its 2011 fiscal deficits. The United States' amounted to a negative 10.3% of its GDP, Japan's was a negative 8.2%, Germany's a negative 4.3%, France's a negative 7.1%, and the United Kingdom's 2011 fiscal deficit amounted to a negative 10.3%.

Although it's impossible to predict the future, by one estimate, this continued deterioration will decrease the supply of safe assets by a further $9 trillion over the next five years, or about 16% of the 2016 projected total.

Foolish bottom line
As anyone who's taken an introductory economics course knows, all else equal, a reduction in supply leads to an increase in price -- in this case, the price of safe assets.

And this is exactly what you see if you trace the ripple effects through the economy. First, sovereign bond yields in the final bastions of safety -- the United States, Germany, and Japan -- are at historic lows. Second, the price of gold has been on an uncharacteristically rapid ascent since 2008. And finally, as my colleague Morgan Housel noted in a column about a potential dividend bubble, the safest stocks are rapidly becoming overvalued.

For contrarian and experienced investors, in turn, it may be worth increasing the risk profile of your portfolio. One way to do so would be to invest in a company like the one identified in this free report, profiling an up-and-coming company that investing guru David Gardner believes is poised for monster returns. To access the report and learn the identity of this potential multibagger before the rest of the market catches on, click here now -- it's free.

At the time this article was published Fool contributor John Maxfield owns Bank of America shares. The Motley Fool owns shares of Bank of America, JPMorgan Chase, and Annaly Capital Management.Motley Fool newsletter serviceshave recommended buying shares of Annaly Capital Management and Procter & Gamble. The Motley Fool has adisclosure policy. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.

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