In Part 8 of the Bermuda Investment Primer Series, Martha Myron looks at bonds, their structures and their role in an economy.

The business of insurance is the most dominant industry in Bermuda, both from an international and domestic perspective, their shares listed on the Bermuda Stock Exchange along with the two largest publicly traded domestic insurers whose shares are for sale, Argus Group Holdings Ltd and BF&M Ltd. Review their BSX listings here: http://www.bsx.com/comp_domestic_company.php

Insurance is the big, big deal in Bermuda — our bread and butter, a basic necessity for just about everyone. Yet, while most of us love real bread and butter — Bermuda honey added for an extra treat — how many local residents understand how the insurance industry operates?

What we mostly think is we need some types of insurance to protect us against large losses: debilitating car accidents, severe health problems, the proverbial blue canvas on the our homes’ roofs after another hurricane’s property and casualty destruction, and the devastating loss of four of our own people — remember Fabian?

We probably know that our chosen insurance company collects our premiums, hangs onto them (shepherding) until the event, if ever, we need financial coverage. Insurance companies manage our risk for us. In return, for taking on that risk, they must manage (and invest) the said pools of premiums to protect as well as making a profit.

Reputable conservative insurance and reinsurance companies utilise a variety of investments to match their premium pool of reserves, some of which are very long-tailed, eg damaging hurricanes don’t occur every year (we hope), we sure don’t have car accidents every year, while some workman’s compensation injuries such as asbestos claims can last for many years after the initial exposure occurs.

We can read about some complicated types of bonds listed on the BSX: catastrophe bonds, insurance-linked securities, and others. Basic vanilla bonds are also part of investment portfolio allocations, not just for insurance companies, but financial institutions, (yes, they buy other bonds beside their own issuances), countries, municipalities, mutual funds, pension funds, etc.

Basic bonds: what are they? Did you ever think that if you loaned someone money, you are their creditor? If you formalise that loan into a binding contract, you have a legal right to be repaid. You may even have a right to attach a lien on the borrower’s property, if the individual refuses to repay you.

Yes, this is true.

Bonds available in the investment world are basically loans that are legally legitimised in a trust document (not shares) that can be sold. Individuals generally cannot convert their personal loans between parties into bonds.

Bonds and other types of loans can also be securitised — a topic for another day think mortgage-backed securities that is the process of pooling and packaging a huge number of individual mortgage loans into a new security.

The components of a bond are the:

• Issuer — incorporated companies: why do they “literally” take on debt, rather than selling more shares in the company we will explore later, also governments and their agencies, municipalities, etc

• Investment bankers act as underwriters who initially buy the bonds from the company and resells them to the general public.

• Underwriting purchasing group.

• Legal team to prepare the documents that are registered with the US Securities & Exchange, for instance.

• Bond trust document — differs from shares — remember you have no equity in the company, municipality or country. You are one of millions of creditors who have, by purchasing bonds, loaned that entity money — with the expectation that you will be paid a certain interest rate in increments, for a certain time frame (say ten years) at which point you will receive your principal back.

The process of issuing bonds: See Morningstar http://news.morningstar.com/classroom2/course.asp?docId=5458&page=1

At the bond primary launch, the bond issuer along with the investment banker sets a dollar offering target (say 500 million in $1,000 minimum increments) for sale to the general investing public. After the initial primary offering is purchased by the investment bank and the underwriting syndicate, bonds now “reside” if you will in the secondary market available for sale to anyone or everyone.

Who are the issuers of bonds, well, millions. The high profile global company, Apple, lists bonds for sale: 2.4 per cent interest with a maturity date of 2023. http://quicktake.morningstar.com/StockNet/Bondsquote.aspx?cid=0C00000ADA&bid=d85cbb7dc2dfa4f872c5cfea9d1ba185&bname=Apple+2.4%25+%7C+Maturity%3A2023&ticker=AAPL&country=USA&clientid=dotcom

Reader question? Why would Apple sell bonds and create a liability when last week, investment media reported that Apple has more than $250 billion in cash?

An interesting fact, too, is that governments, municipalities, agencies sell / buy bonds — but do not sell shares to investors. Now that would be something, if we all could buy shares in the Bermuda Government. Why can’t we? Or are we all shareholders already, under a blanket assumption that since we are all taxed, we all have a stake.

Would any reader like to explain that concept to the rest of us?

There are almost endless variations of bonds, with many conditions

• Plain vanilla — US Treasuries for example.

• Bonds with embedded put options.

• Municipal bonds, typically, revenue or general obligation — why those differences discussed later, read Puerto Rico going into bankruptcy.

• Zero coupon bonds.

• Callable bonds.

• Convertible bonds.

• And many others.

Bonds have credit ratings: high yield is not the same thing as high grade. They are polar opposites!

What, where and when do bonds have other roles in capital markets? Consider bonds used by governments for country money flows, maintaining capital reserves in financial institutions, diversification, protection, liquidity, and serious safety for investors — also known as capital flight.

Do individuals purchase bonds for the same reasons? You probably have a variety of bonds in your pension fund — have you looked recently?

What if bonds were listed for sale and no one came to the party? Bond issuers can default — that is the entity that issued the bonds can refuse to pay back the principal and interest due to financial insolvency, or other political, legal, financial difficulties. How many times did Argentina default on their bonds?

Next week: the defaults, the detractors, the debt, the discounts and premiums paid, the pricing, the research behind the issuer, understanding a bit more about management of an insurance capital reserve portfolio, reading a corporate balance sheet for cash flow, cash reserves and ratios — what is the requirement for Bermuda insurance companies to meet EU Solvency II, US capital reserves and so on.

Finally, keep in mind, readers, that this is just a basic overview. If I become too esoteric, you may end up bored to tears, and the sophisticated investors among may understandably deride the results.

Martha Harris Myron CPA PFS JSM: Masters of Law — International Tax and Financial Services; Pondstraddler Life™ financial perspectives for Bermuda islanders with multinational families and international connections on the Great Atlantic Pond. Contact: martha@pondstraddler.com