It looks like Warren Buffett will have to update his main argument against gold:
The commodity itself isn’t going to do anything for you….it is an entirely different game to buy a lump of something and hope that somebody else pays you more for that lump two years from now than it is to buy something that you expect to produce income for you over time.
Not anymore. The precious metal Buffett shuns can now be directly used to generate interest.
A gold bond unlike anything that can be found in today’s markets is being offered by Rand Merchant Bank, the corporate and investment banking arm of South Africa-based FirstRand.
The FirstRand Gold Bond, as it is called, was listed through the Johannesburg Stock Exchange on August 12, under the code “FRK01.” The first issue amounts to two billion rands, or a little over $185 million.
As boring as bonds normally are, this one is unique in that it is solely bought and redeemed through South Africa’s Krugerrand gold coins.
In a time of well-founded distrust in central banks and the unchecked expansion of monetary bases worldwide, this appears to be a very innovative and appealing hedge against the stock market, and an alternative to letting gold sit around and collect dust.
So is it worth buying the gold-backed bonds? To get an adequate answer we’ll have to break this all down a little further… Then we’ll see if we should jump aboard. Let’s get started.
How it Works
To purchase these bonds, investors will first have to purchase Krugerrands, then loan them right back to Rand Merchant Bank. The bonds earn .5% interest and are redeemed after five years.
As for the actual payout, at expiration the value of the bond is determined by the current gold price, the dollar-to-rand exchange rate, and the interest earned; calculated in terms of ounces of gold represented by Krugerrands.
Investors can either claim their gold or cash out when the time comes to settle the loan.
So far, this is simple, but that won’t last for a vast majority of us. International investors in these South African bonds will face a number of complications and additional costs:
- You will have to work with a brokerage that has access to the Johannesburg Stock Exchange.
- You’ll get hit with a fee to buy rands with dollars (or your local currency) when you buy in and cash out.
- There will be much higher brokerage fees. A quick look at the Fidelity web page lists a $21 dollar fee for online transactions and $56 for an assisted trade in South African markets.
- South Africa taxes capital gains as income for non-residents. The IRS will double dip, with some of it offset by a foreign income credit.
- There is no reasonable way to cash out in gold Krugerrands. FirstRand has no information on what it would cost to ship gold to bondholders, or even if they’ll do it. If this is possible, we can count on very large shipping and insurance fees.
- And of course, this investment comes with a set expiration date. Investors cannot choose when to cash out, leaving them at the whims of the price of gold.
Still A Bond
Although it is purely gold-denominated, remember what this bond truly is — a five-year loan to an investment bank.
South Africa is facing a rippling finance sector squeeze following the collapse of African Bank. The government stepped in to bail it out, but is forcing bondholders to take a 10% haircut.
FirstRand, along with three other major South African banks, just had its credit rating downgraded by a notch, with the possibility of more to come.
Although FirstRand and the other banks appear fine for now, they face great uncertainty while being forced to invest in a salvaged portion of African Bank.
Investors should also consider the motivation to issue these bonds at all. Rand Merchant Bank plans on using the proceeds of this bond issuance to fund its gold trading desk activities.
Essentially, it has found a way to capitalize on interest in gold and moving away from fiat currencies to bring in incredibly cheap financing, at about a tenth of the going rate for bonds in South Africa.
In this context, it doesn’t matter if the bonds are gold-denominated. You are still completely exposed to the health of the issuer in a shaky sector and economy, all at a fraction of the going rate.
Who Benefits?
For South African investors, facing lower fees and much higher inflation rates around 6.3%, these bonds make sense.
If you price gold in dollars and compare it to the gold price in rands since the beginning of last year, there is roughly a 20% difference, all due to the depreciation of the rand.
That advantage will disappear if you convert gold to rand, then rand to dollars, pounds, euros, etc.
There are many factors at play in currency exchange rates, but for an internationally traded commodity like gold, the “law of one price” holds up pretty well. Since arbitrage situations are small and fleeting at best, the relative value of gold in dollars or rands lines up almost perfectly with exchange rates.
With the structure of this bond, it becomes clear that there is only one way for international investors to make a significant profit from these bonds — rising gold prices.
So, from my perspective, the advantages of FirstRand’s gold bonds are limited to South Africans.
Introducing extra risk for a low interest rate, locking up funds for five years, and losing flexibility to enter and exit positions simply isn’t worth it without benefiting from inflation protection in the local currency.
Having said that, there is something I really like about these gold bonds: the promise of emulation in other countries and the expansion of alternatives to purely fiat currency-denominated investments.
We saw it start as interest in gold, along with gold prices, spiked after the recession and unprecedented QE experiments.
Then Bitcoin burst onto the international stage as a means to avoid central bank and government control. Plans are in the works for a gold-backed digital currency called InnCoin.
Now we are seeing corporate bonds being issued in gold… not the slumping fiat currency of the company’s home country.
Let’s hope more and more options become available to opt out of the ever-increasing risks to currencies, and thus our savings.
