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Bonds, bootstraps and bottomless pits

Continuing the Bermuda investment primer series

Accompanying the Bermuda Government release of the Budget numbers for this fiscal year was a small notation that “later in the year” there would be a bond offering for local residents.

Actually, this Budget was not a balanced budget, since the expenses outweighed income, that is, they were not balanced by an equal amount of revenue, or a surplus.

It was a spending plan no balancing about it. Furthermore, within the Budget release were plans for increasing the debt ceiling yet again by borrowing from foreign investors and from Bermuda residents. An additional comment directed to local residents was that a local bond issuance would release “surplus deposits in the banking system, that likely would achieve higher returns by transferring to the local Government bond.”

So, if you are going to have the opportunity to buy local bonds from our very own Government, now is a good time to develop a thorough understanding of bond structures. You will be able to clearly assess for yourself then, whether the local bond offering is an opportunity for you or something else indeed.

What is a bond?

Well, for starters a bond is not a stock, or an equity share in a company. A bond is a loan you have formally made to company, a government, a municipality, a quango, etc. These entities become indebted to you, although that does not necessarily mean you hold any power in how your money is spent. Bonds are a promise to pay your money back sometime in the future. And, for the use of your money in the meantime, the bond issuer will remit an interest payment to you (the coupon rate).

It is worth repeating that owning a bond does not mean you have real ownership of an asset, such as a piece of a profitable company, always a desirable goal for an investor since the share of profitable companies can increase exponentially over time. You cannot own shares in a government, even though it is always stated that we all are stakeholders. Perhaps, that may be implied, but as Bermuda citizens, we do not have equity rights, unless you want to count your inalienable right to exercise your voting power in a democratic society. Owning a bond(s) means that you own a promise (not a guaranteed right) to be repaid your principal and interest over a certain period of time.

Why sell/own bonds?

There are two perspectives here: one of the Government selling the bonds and the opposing viewpoint of the individual (company, partnership) buying the bonds

The Issuer/Seller as mentioned above can be a Government, a company, a municipality, and so on. Issuing bonds is an easy alternative to raise capital than issuing stock. The proceeds can be used for example, enhance product expansion into new markets, to buy out major shareholders, to fund a specific research and development projects, rebuild capital structures, or pay off older debt issued at higher interest rates. Always, entities borrowing (issuing bonds) are focused with an eye on the liability to the future as the debt must be paid back.

It is also a way to maintain control of a company or country's finances, although rating agencies and bond holders will want to review complete financial statements on the strength of the company or country issuing the bonds. Governments also use bonds to increase / decrease the money flow of currency in the country.

The purchaser/owner of bonds.

Globally, investors love high-quality, high-grade sovereign debt because of its safety. In the short term, very high-grade debt (US Treasuries) is used as near cash as the secondary bond market is a highly liquid global market with millions of transactions taking place every day.

Bond purchasers own bond debt as alternatives to more volatile stocks (although, this is not necessarily accurate, it is a perception). Bond interest payments are counted on to provide consistent fixed income for those facing retirement, and to meet other investment objectives.

How are bonds issued?

It is pretty extensive investment process, involving a number of steps and a host of professionals using an underwriting process or holding public auctions. Having said that, Bermuda is always unique, and neither of those general descriptions may fit the ultimate launch of a bond offering in Bermuda.

A bond in the old days, you know way back when, looked like a fancy piece of paper. On it was inscribed the following:

The name of bank, government, or other company issuing the bond

The face value the principal value due to you at maturity amount of the bond, generally, $1,000

The date the bond matures and the principal has to be returned to you

The Coupon Rate, also known as the interest rate

Bonds today are almost universally held in electronic format in investment custody accounts as paper certificates tend to get lost, burned inadvertently in woodstoves (true story), thrown out with the newspapers, and mislaid. There was also the time sensitivity in rationalising a paper bond certificate for sale to another investor on an exchange.

If you decide to purchase bonds, what will the money be used for? Ah, now that is the sixty-four thousand dollar question. You may feel quite patriotic about lending your hard earned money to government (and getting interest earnings in return), if for instance, the proceeds are all used to pay down foreign US dollar government debt. If, the money is used domestically, instead, to prop up a spending plan for current government expenses, will you feel that that you've got to pull up your own bootstraps while hoping that you will get your principal back?

Next: Bond Safety and credit quality of Bonds are Rated according to the Alphabet, but the biggest concern always, is will I get my money back? Volatility in markets (the rise and fall in value of a bond), choice of currency, effect of change in interest rates, inflation pressure, and comparisons to preference shares (which tend to act like bonds).

Martha Myron, JP CPA CFP (US) TEP specialises in independent fee-only cross border investment, tax, estate, and strategic retirement planning services for Bermuda residents with United States and multinational connections, and US citizens living and working abroad. She is a Masters In Law candidate and the American Citizens Abroad Country Contact for Bermuda. www.americansabroad.org For more information, contact mmyron[AT]patterson-partners.com martha.myron[AT]gmail.com or 296 3528 at Patterson Partners Ltd.

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Published March 03, 2012 at 1:00 am (Updated March 03, 2012 at 6:47 am)

Bonds, bootstraps and bottomless pits

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