Video: Do you really know what a bond is?

A bond is an IOU. An IOU is a type of loan. And a loan is one of many types of debt. With a bond, the borrower promises to pay back the lender in a specified period of time at a specified interest rate. 

Our government recently issued a US$475 million bond for 15 years at a rate of 4.138 per cent per year. The bond was purchased, I presume, primarily by non-Bermuda residents, that is, foreign institutional investors — banks, pension funds and insurance companies. 

The local taxpayer will have to pay bondholders $19.6555 million ($475m times 0.04138) in interest each year and at the end of the fifteenth year US$475 million in principal. It would not be unusual for the government to repay the principal by issuing another bond. In other words, the government may choose to rollover its debt. 

According to the most recent Budget Statement, our government has about US$1.5 billion in outstanding bonds. To put this into context, the amount of economic activity (gross domestic product) generated locally is around $5.5 billion — the debt to GDP ratio is, therefore, 27 per cent. 

In the US, investors, many of whom are non-US citizens, lend money to the government. If, say, you are buying a US$100 10-year Treasury Note, also known as a 10-year government bond, expect to receive about $2 each year until the end of the tenth year at which point you get your $100 back. 

If you, however, were to lend money to the Greek government, you should expect a higher return because the risk of default, not getting your principal back, is higher. The greater the chance of a default the higher is the interest or yield of a bond. As an investor, you need to balance the risk of not getting your money back with the yield offered by the borrower. 

No country can claim debt virginity. They have all modified or defaulted on the initial repayment plan. 

• Why does government issue them?

From time to time, Governments and businesses need additional funding to help with the building of, say, a school or a bridge or purchasing of equipment or inventory. A business has the option of financing big projects with debt or equity. Rather than owe a lender, a business could have offered a lender a share in the company. This is known as equity financing. Governments cannot easily offer lenders a share of the island’s public assets — beaches and parks, roads and ports, and government real estate. A government’s principal way to raise funds is through bonds. 

• Should we be worried when they do? 

You should worry when a government issues debt, just as you should be careful taking on personal debt.  It’s not that debt is bad — it’s that too much is deadly.  Too much economy-wide debt also exposes the financial system of banks, insurance companies, and pension funds to a huge amount of risk. 

We live in uncertain times. Life is subject to black swans — highly unlikely events that when they occur have devastating impacts.

The 2008 recession is a case in point. In 2007, very few people saw it coming.  Prior to the recession, many made a killing in the real estate market as well as the stock market. As wealth increased so did spending. Then there was the multiplier effect of all that new spending. As a result, the economy boomed.  Unfortunately, much of the new spending came from borrowed money — mortgages, home equity loans, as well as consumer and business loans. In other words, the new spending depended increasingly on debt.  It was as if the economy was on steroids. 

The dangers associated with debt hide in the failure to realise its potential harm. The Bermuda Government can easily handle $0.5 billion of debt; the probability of default is small. The probability, however, of defaulting on $1 billion of debt is more than twice the probability of defaulting on $0.5 billion of debt. Similarly, the probability of defaulting on $2 billion in debt — despite being only four times as large — is considerably more than four times the probability of defaulting on $0.5 billion of debt. There is a point beyond which further increases in debt exposes the island to an untenable amount of harm. 

Are we close to the debt threshold? Yes we are.  What should we do? Tread carefully as we take on more debt over the next two to three years. Taking on additional debt sounds illogical, but is necessary to stem the falling tide of economic activity over the last four or five years. There is a good chance that government’s debt will pass the $2.5 billion mark by the end of 2015; that’s an increase of 67 per cent.  Thus, the need for a medium term plan to sketch, in broad terms, the process of debt reduction — an exit plan from debt. 

I’m hoping for a medium-term debt reduction plan.  That is, a five to seven year plan, starting in 2016, outlining the nature and approximate size of spending cuts and tax increases.  People deserve to know how the debt we are accumulating is going to be repaid.  Many personal and business plans hinge on whether and when these changes in spending and taxes occur.  I fear that — as was my experience with Santa and the tooth fairy — I will be disappointed.

• Find out more about how you can learn more by emailing [email protected] or calling 239-4099