Opinion: Can El Salvador's Bitcoin Bonds Succeed?
What is a Bitcoin Bond？
On the evening of November 20th local time, El Salvador's President Nayib Bukele announced at the Bitcoin conference LABITCONF that El Salvador will issue a $1 billion bond with a ten-year maturity and 6.5% coupon. The funds raised from the bond will be used to build a city called "Bitcoin City," also known as the "Volcano Bond" due to the city's use of volcanic thermal energy to generate electricity.
Meanwhile, El Salvador has entered into a partnership with Blockstream and iFinex (i.e., Tether and Bitfinex) in which the bonds will be issued on Blockstream's liquid chain and sold on iFinex's new exchange BitFinex.
Half of the funds raised through the sale of the bond will be used for the construction of Bitcoin City, and the other half will be used to purchase bitcoins. Thus, half of the bond is "backed" by bitcoin assets. The bitcoins will be locked up for five years, and future proceeds from the sale of these bitcoins, beyond the repayment of principal, will be split equally between the Salvadoran government and the bond purchasers. In other words, if an investor buys $100,000 worth of volcano bonds, assuming the price of bitcoin doubles in the future, that means the investor will not only get 6.5% interest per year, but also half of the profits from the bitcoin investment, or another $25,000.
Amazing interest rates on bonds
In an era of zero or negative interest rates, the interest rates on Volcano Bond can be tempting. An simple interest of 6.5%, can amount to 146% for 10 years by yearly compounded, considering the rise of bitcoin price. By contrast, the annual rate of 10-year Treasury bond is only 1.63%, which can be almost equivalent to cash (1).
As the word, no good goods cheaper, the prestigious rating agency adjusted El Salvador's credit rating from B3 to Caa1(2) on July 30 this year. The downgrade partly due to El Salvador's "Bitcoin Act," and the Caa1 rating means that bonds issued by El Salvador have been placed in the "junk bond" category. Junk bonds are bonds that have a very high risk of default. If a bond is rated as junk, it can largely restrict access to institutional funds.
Bitcoin City, on the other hand, is a city that is completely exempt from income tax, capital gains tax, property tax, and personal tax, with its only source of tax being a 10% value-added tax.
Why not just buy bitcoin?
In fact, there are also a large number of outstanding Salvadoran national debt on the market today, and 10-year national debt often carry annual interest rates as high as 13%. The reason why El Salvador can offer such high interest rates remains because it has an extremely high risk of default.
Currently, the most similar product on the market to the Volcano Bond is a 10-year bond maturing on April 10, 2032, which is listed on the Luxembourg Stock Exchange and has an interest rate of 8.25% per annum, which is much higher than the Volcano Bond.
Not only that, but the 10-year bond is also far cheaper than the Volcano Bond, which currently has a net value of 72.54 cents, meaning that investors can currently buy a bond of the same level (also issued by the Salvadoran government) with a much higher interest rate than the Volcano Bond at a 72% discount, if they are not worried about losing their principal.
However, the fact that the Volcano Bond is half "backed" by Bitcoin makes it even more speculative, as investors also have the potential to gain from the appreciation of Bitcoin, which according to one of the Volcano Bond's partners, Blockstream's Chief Strategy Officer Miao Yongquan, will reach a price of 1 million dollars a pop.
If the price of bitcoin can rise to $1 million a piece within five years, the Volcano Bond will have no problem paying off its principal and interest. But the higher the price of bitcoin goes, the more it struggles to rise, having only tripled in the last four years. If it needs to reach $1 million in the next five years, it will need to rise nearly 20 times in a similar cycle.
Of course, it's not impossible for Bitcoin to go to $1 million in five years, so investors are obviously considering another question: why not just buy Bitcoin? Some people have calculated that if bitcoin does go up significantly, taking $72,000 and buying $100,000 worth of 10-year Salvadoran treasury bonds, with the remaining $28,000 in bitcoin, would be a much higher return than spending all $100,000 on volcano bonds, for the same $100,000.
That said, if you think of volcano bonds as a speculative item, it's not high enough return; if you think of it as a low-yielding financial product, it's too risky. According to Coindesk author Omkar Godbole's speculation (3), many countries with poor credit ratings have difficulty borrowing money from the market even if they offer very high interest rates.
In June of this year, the International Monetary Fund IMF voiced its opposition to El Salvador's adoption of bitcoin as a fiat currency(4), and as a result, most outsiders assumed that El Salvador would have difficulty borrowing money from the IMF. However, the opposite may well be true: Due to deteriorating credit and political conditions over the years, El Salvador's President Nayib Bukele has predicted that it will be difficult to borrow money from the IMF, and has come up with the "miracle" of using bitcoin as a fiat currency, and this volcano bond is another one of El Salvador's "miracles" to borrow money. The volcano bond is another of El Salvador's strange tricks to borrow money.
El Salvador is still aiming for the giant whales of the crypto world, as the president said, "You know there are a lot of whales on Bitfinex, so I don't think it's a problem to fill a $1 billion bond".