El Salvador’s bitcoin bonds: a terra incognita

It was recently announced that President Nayib Bukele of El Salvador wants to build a bitcoin city in his country. The construction plans must be financed, among other things, by means of so-called ??????bitcoin bonds???????. That is why in this article we will take a closer look at these bitcoin bonds.

Bitcoin bonds, or bitcoin bonds. Before we discuss this innovation of an age-old financial instrument, we first explain what exactly a bond is.

What is a Bond?

When a government or corporation wants to borrow money from the public over the long term, it usually does so by issuing or selling debt securities. A kind of loan. These debt securities are popularly referred to as bonds . A bond has a fixed term, which is often between five and thirty years. Interest is paid once or twice a year , which can be variable or fixed. At the end of the term of the bond, it will be repaid in full. In fact, this is a fairly simple financial instrument. To dive a little deeper into the matter, we use the (yet to be issued) bitcoin bonds of El Salvador as an example, in which some terms from the financial jargon will emerge.

Example

El Salvador wants to borrow $1 billion for ten years, then invest $500 million in bitcoin and use it as collateral (with a five-year lock-up period) and use the other $500 million to build the energy infrastructure of Bitcoin City. The interest rate on similar government debt ( emerging market debt ) is between 6% and 9%. El Salvador opts for an interest rate of 6.5% and thus pays 0.065 x $1,000,000,000 = $65,000,000 per year in interest for ten years. In jargon, this amount is also called the coupon

Because the coupon from the El Salvadoran example is fixed and paid annually, this type of bond is also sometimes referred to as a level coupon bond . The amount that is paid back at the end of the term is also known as the face value or par value . By dividing the coupon ($65 million) by the face value ($1 billion) we get the so-called coupon rate of the bond. In other words, the interest rate of 6.5% that El Salvador must pay annually. At the end of the term – or after ten years – El Salvador will pay back the $1 billion.

junk bonds

Bonds are often rated by a credit rating agency. The three largest credit rating agencies in the world are Fitch Ratings, Moody’s and S&P Global Ratings. Credit rating agencies are basically an assessment of the creditworthiness of a particular government or company. This refers to the probability that a government or company will default on the payment of the bond and the protection of bondholders in a default scenario. Consider, for example, a bankruptcy in such a scenario.

The highest rating bonds can have are AAA or Aaa. Such bonds are thus rated the best and have the lowest risk for investors. However, a large portion of bonds are rated as low-grade or non-investment grade . Such junk bonds (BB, Ba, Ca, CC and C) are also referred to as junk bonds .

Credit rating agencies have already labeled El Salvador’s (yet to be issued) bitcoin bonds as negative in advance. El Salvador passed a law last June that gave bitcoin legal tender status. According to Moody’s, this fact has led to weakened governance and also increased the (already existing) tensions with other countries. The credit rating agency therefore changed the status of the country’s bonds from Caa1 to B3 at the time, ie given the junk status described above.

 

The new bitcoin bonds will therefore most likely not be received with cheers by the various credit rating agencies. Marc Chandler, chief strategist at Bannockburn Global Forex, told CoinDesk in an email that he wasn’t too hopeful either. He said, ?ǣ I suspect El Salvador’s bonds are already quite risky, adding bitcoin will exclude most retail and institutional investors .?ǥ

Lyn Alden, founder of Lyn Alden Investment Strategy, was a lot more optimistic on Peter McCormack’s podcast, What Bitcoin Did. She paraphrased the following about bitcoin bonds: ??????El Salvador is in fact following Michael Saylor’s example, but for a country. They issue debts in dollars and use them to buy bitcoin, among other things. If it pays off, that would be great??????.

Bitcoin Bonds

Now a little more about the bonds themselves. The plan from Blockstream, the bitcoin company that designed the bonds, is to issue the bonds on the Liquid Network , a Bitcoin side-chain. Because this network is lightning fast and has low transaction costs, it is possible to invest as little as $100. The bond issuance process will be facilitated by Bitfinex; a bitcoin exchange where there is a lot to do due to the nature of its business and the legal procedures in which the exchange has become embroiled. To facilitate the issuance process, El Salvador is working on a new securities law. Under the law, Bitfinex would receive the first license to operate an exchange, said Samson Mow, Blockstream’s chief strategy officer.

Furthermore, the bitcoin bonds entitle the holder to an additional coupon (profit distribution) that will be paid out quarterly, after the five-year lock-up period has expired. The coupon will be generated through incremental sales of a portion of the $500 million worth of bitcoin. The link with bitcoin makes the bonds a lot more interesting than ??????normal??????? bonds, because according to some, the price of bitcoin can only go up in the long term. In any case, the bitcoin bonds can be called innovative.

Completion

It is interesting to keep an eye on whether the innovative bitcoin bonds will actually materialize. If the bonds come, the success will depend, among other things, on whether other countries follow this example and of course also on the success of Bitcoin itself. Blockstream is pinning its hopes in this on a model that suggests one bitcoin is worth $1 million in five years. The future will show whether this assumption is correct. In any case, bitcoin bonds can accelerate the potential for hyperbitcoinization , giving countries such as El Salvador an alternative to International Monetary Fund (IMF) loans.

Read our dossier on bitcoin in El Salvador here.

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