Understanding bonds — part 1. The Bermuda Investment Primer Series.

The recent focus on Donald Trump’s leaked (or however the information was obtained) 1995 partial personal tax return by the New York Times brings up the very interesting topic of junk bonds.

The enormous loss of almost $1 billion — considered a lot more significant 20 years ago — stated on the above tax return was attributed, by various analysts, to the financing structures of a casino and possibly other large-scale developments.

What does junk have to do with bonds and financing? Don’t most people take a loan known as a mortgage to purchase or build property? Well, no, not always. In fact, in business circles, other financing forms probably take precedent.

At this juncture, we will just take a brief look** (see link at US Securities & Exchange filing below — an extremely tedious, highly detailed multi-page look at a complicated corporate / partnership operation) at one business structure, the Trump Taj Mahal in Atlantic City, launched in 1990 by Mr Trump. The new venture was supported with a series of bond issues, paying an estimated 11 per cent interest rate annually to the bondholders, to fund acquisition and construction.

Those were heady days (oops, not a reference to the famous hair style) even though it was only a few years after the infamous 1987 Black Monday stock market crash. The hype was that Atlantic City was to receive much needed revitalisation and many, many people stood to benefit from the influx of new businesses.

However, in rather short order, probably not more than a year later in 1991, the Trump Taj casino model was deemed not sustainable according to the US SEC report — meaning that there was insufficient cash flow to meet the debt obligations to the bondholders for their interest and principal payments.

The entire scheme was placed into a legal structure of reorganisation and renegotiation of repayment terms by the debtors of the corporation. In investment jargon terms, creditors of the Trump Taj had to accept a “haircut” or another form of ownership in lieu of debt repayment.

What on earth does all this mean? We will explore the concept of bonds, conversions, repayments, junk or quality credit ratings, risk coupon versus yield, market interest rates, discounts and premiums, surety bonds with guarantees and yes, haircuts and as many other basic components that we can — without boring you to tears, or having you turn off learning in frustration.

Bonds appeared first on stone in 2400BC in Mesopotamia***, where the payment of grain was guaranteed by a surety. Bonds then evolved into paper missives of a sort by the clever Venetians in the 11th to 14th centuries as government bonds to fund wars, then, bonds were upscaled into securities trading as annuities.

Various governments through the latter centuries, first by the Bank of England to fund wars against the French in 1693, then other countries followed suit delving into patriotic fervour to fund wars across continents, including the US Revolutionary war — where $27 million in the late 1700s was an astronomical sum.

In the early 1900s the US issued the first US Treasury bond, so called Liberty Bonds for funding the First World War.

Modern day bonds are used primarily for finance, investments, capital structures, economic money flow circulation, and business commerce. And we hope, not for war.

Bonds are fascinating things. One might say that they are formalised versions of informal gentlemen’s handshake, or a complex version of a simple IOU between friends, but no matter the shape, they are still a promise to repay. They are almost never considered ownership of an asset — but an agreement between the borrower and the lender.

Ordinary bonds can be confused with mortgages, but the big difference there is that a mortgage has attached collateral giving the lender the right to liquidate the property, the equipment, or something of more than equal value in order to be repaid.

How then does a bond work? Someone, or many, thousands of years ago had a brilliant idea. Instead of one friend, or hundreds of friends, neighbours, businesses, loaning another money in exchange for interest income and hoping for a repayment down the road, why not make the act of borrowing and lending an independent security.

A real stand-alone legal entity contract, so to speak, that can bring bonds for purchasing and selling right to the public, is called a bond indenture, a deed of trust. The trust indenture is a complex binding document between an appointed trustee and the bond issuer, who may be a government, a corporation or another form of commercial structure.

A quick aside to wrap up the end of part one of this section of the series. Junk bonds, by definition, almost always offer very high rates of interest when compared to market interest rates of the same time frame. They are considered much higher risk, than say a US Treasury Bond or a Canadian government bond. And more often than not, junk bonds do not return all of the original principal invested, thus the name.

Teaching or writing about investments during Bermuda finance employment positions, I liked to refer to The Donald bonds — which were listed every day in the print in the Wall Street Journal — heavens, old-fashioned newspapers. Everyone knew who Mr Trump was even way back then.

My question was always the same, whether the bonds were from Trump, or from Brazil or Argentina — that were often listed close by, do you think you will get your full amount of the bond principal back?

For instance, more than once, the 2002 year comes to mind, Argentina government bondholders watched as Argentina bonds, at that time paying about 14 per cent interest, went into default while the government defiantly stated they would pay only a lower percentage of the principal back. Around 30 per cent of the principal investment was offered and many small investors accepted.

Large creditor bondholders fought back, but it took 14 years to finally settle early this year — 75 per cent of the principal will be returned to them.

Next week: part 2, bonds, debonded to basics.

*New York Times http://www.nytimes.com/interactive/2016/us/politics/donald-trump-taxes-explained.html?ref=politics

** US SEC https://www.sec.gov/Archives/edgar/data/835544/0000950130-96-000993.txt

*** http://bondfunds.com/education/a-brief-history-of-bond-investing/

Martha Harris Myron CPA 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.