Friday, 30 April 2010

Solidarity "bonds"? Thank you but no thanks

What a wheeze. The brains trust of the Irish government has launched a "National Solidarity Bond". Handing the cap around for our poor impoverished nation (hey buddy, can you spare a dime?).

Huzzaahhh. We're saved.

I wonder if they will get many takers? Let's pop the hood on this bad boy and check out what makes it go.

One problem right off the bat is that there is a blatant lie, right there in the name. This isn't a bond, it is a fixed term deposit. To make this a bond it would have to be a tradable security. It isn't tradable, so it isn't a bond.

Next, what do you get in return terms on this "National Solidarity Fixed Term Deposit"? A simple bit of financial arithmetic gives the answer as 4.1%. This comes from an annual 0.75% "coupon" after tax (a term we should on use for a real bond), plus an interest free bonus of 40% on maturity. You only get the bonus if you hang on for 10 years. If for some reason you need the money and have to withdraw, the maths is simple, you get a 0.75% after tax return. Is that a good return? Well, buy a real Irish Government bond today and you would get 5.2%. For the majority of the population that don't pay income tax it is a nice earner, if you think they are good for the money. Pay a top rate of tax and you would get around 2.9% per annum

Let's think a bit more about that 4% return though. So you get 4% annualised return, but all paid on maturity (your investment has a long "duration"). What might go wrong? Well, I mentioned that some misfortune might befall you, say after 9 years and you just have to take your money. Then you lose virtually your entire return.

Think also about interest rate risk. You are locked in to this return and if interest rates happened to go up significantly, say after five years, you would be sitting on a very poor return.

Think about inflation. 4.1% return is nominal. If inflation average 2% you get a 2.1% real return. But if it averaged 4% you would get a zero real return. It is easy now to think that inflation will always be low or non existent, but it is a dangerous animal. And the back end nature of your return, which cannot be sold on to anyone else (remember, this isn't a real bond), means that even if after a couple of years, you begin to get worried that inflation will rise, it is too late, you've lost.

So Buy real Irish Government bonds at 5.2%, or 2.9% after tax or a 10 year fixed term deposit with draconian early withdrawal penalties at 4.1% after tax? I think I would take the former, if I was stupid enough to lend anything to the Irish Government.

What puzzles me is why they didn't do something more sensible? How about a zero coupon government (real) bond issued at 34% discount to par (i.e buy for €66 and €100 is repaid in 10 years time). Capital gains on government bonds are not subject to tax for Irish residents, so there is your 4.1% return, but it is tradable. All they needed to do was arrange a deal with an Irish asset manager or life assurance company to package an investable fund for small investors. They could have even picked up the puny cost and fees involved (probably less than 0.1% per annum) allowing free entry and exit at a single price. Easy peasy. It is the same result for the Irish government - if they expect to fully repay interest and capital on everything they borrow.

And that is the catch (and why I lied). I do know why they went down the fixed deposit route. Think about it yourself. Why would you ask to borrow money from someone and promise to pay any material return only if they didn't ask for their money back before 10 years? In effect, allowing you to avoid paying any interest to anyone who, perhaps, started to worry in a few years whether you would repay anything?

You probably doubt your own creditworthiness.

But I just can't get passed the name. "National Solidarity Bonds". I just wouldn't enter into any bargain with someone who opens discussions with a lie.


yoganmahew said...

"It is tradable, so it isn't a bond."


Geckko said...