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Let the FDIC back your portfolio

Investor Daily: Institutional investors are snapping up FDIC-backed bonds. Here's how you can get in on the action

By Mina Kimes, reporter
Last Updated: December 18, 2008: 1:33 PM ET

(Fortune) -- In times of volatility, there's no place like treasurys, but surging demand for the safe, government bonds has sent their prices up and driven their yields into the ground, giving you little bang for your buck. Luckily, a risk-free alternative with attractive yields is now on the market: corporate bonds backed by the FDIC.

The Federal Deposit Insurance Corp. created the new investment vehicle in late November to help ease short-term liquidity concerns for financial institutions. It enables corporate issuers covered by its Temporary Liquidity Program to sell default-free debt to risk-averse investors.

Banks such as Goldman Sachs, JPMorgan Chase, and Bank of America (as well as the capital arms of General Electric and American Express) have auctioned off the bonds, which are AAA-rated and explicitly guaranteed by the federal government through 2012 (most of them mature by then, or earlier).

Yet despite the absence of risk, FDIC-backed bonds' yields are still around one to two percentage points higher than those of treasuries. "They deserve to be lapped up - they're a gift from the government," says Rajiv Setia, Barclays' fixed income strategist. "When you're just making one cent off of treasuries, anything you can pick up over that is huge."

Not as easy as it sounds

Institutional investors have jumped at the opportunity. Companies have sold a collective $80 billion in FDIC-backed debt, according to Reuters, and Barclays estimates the total will hit $350 billion to 450 billion. Craig Coats, co-head of fixed income at Keefe, Bruyette & Woods, says, "Anyone with treasuries in the two- to five-year range should sell those and buy these immediately."

For the average investor, that's easier said then done. As with any corporate bond, you can buy the FDIC-backed debt through brokerages such as Charles Schwab, but they're not explicitly labeled as such.

Schwab spokeswoman Laura Edge says retail investors can call the company to find out when and where these bonds are being issued. She points out, however, that the individual bonds yield less than other, more basic instruments. 3-year CDs, for example, yield about 4%, but they also lock in your money for the designated term.

How you can get in

One way for individual investors to benefit from the FDIC's gamble is to look for funds with decent yields that are buying the debt. Eric Jacobson, a fixed income fund analyst at Morningstar, says government funds, which typically peddle in Fannie Mae (FNM, Fortune 500), Freddie Mac (FRE, Fortune 500), and Ginnie Mae issues, are snapping up FDIC-guaranteed bonds.

While these funds usually yield only slightly more than treasury-only funds, spreads have widened in recent months: Barclays' index of agency bond funds yields 3.3 more percentage points than its 3-to-7-year treasury index. Rod Olea at CNI Charter purchased FDIC-backed debt for his Government Bond Fund, which yields 3.48%.

As undervalued funds acquire more secure debt, "the spreads will narrow," says Setia. When that happens, investors who buy and hold will benefit from the rising prices.

Diversified corporate core funds are also investing in these risk-free bonds. Mohamed El-Erian, co-chief investment officer of bond giant PIMCO, recently added the debt to the company's corporate funds across the board. Vanguard's Total Bond Market Index Fund, which has a yield of 4.52%, has also added FDIC-backed debt to its portfolio.

"It's a safe way to get back into the corporate bond market," says Olea, who admits that he's still waiting to see which fund - government or corporate - is better suited to hold the instruments. Because it's still unclear to many managers, you should contact them to see where they're putting the bonds.

Spreading signs of life

Some analysts worry that FDIC-backed debt may clog the market for corporate bonds, making non-insured offerings even more difficult to sell. But Jacobson believes that the incoming flood of safe bonds will have a positive impact on the entire fixed income market.

"If $400 billion is issued, there may be crowding out," he says. "But hold on - that's $400 billion that the banks can now lend with, and the lending should go back to the corporations."

Since the program began in late November, yields of both agency and investment grade corporate bond funds have dropped slightly, suggesting an early-winter thaw in the credit markets. The narrowing spreads aren't solely tied to FDIC-backed bonds (the government has also bought up agency debt), but the new investment vehicle indicates a resurgence of life outside of treasuries.

"Any activity is good activity in the corporate bond market," says CNI's Olea. "It's time to dip your toe back in." To top of page

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