What is El Salvador’s new game? Bitcoin-based “volcano bonds” hope that whales will pay the bills

Wu Shuo Author | Tan Shu

Editor of this issue | Colin Wu

1. El Salvador issues Bitcoin-based “Volcano Bonds”

On the evening of November 20, local time, Salvadoran President Nayib Bukele announced at the Bitcoin Conference LABITCONF that El Salvador will issue a $1 billion bond with a ten-year term and an annual interest rate of 6.5%. The funds raised from the issuance of the bond will be used to build a city called "Bitcoin City". Since the city mainly uses volcanic thermal energy to generate electricity, the bond is also called "Volcano Bond".

At the same time, El Salvador, Blockstream and iFinex (ie Tether and Bitfinex) reached a cooperation agreement. The bond will be issued on Blockstream's liquid chain and sold by iFinex's newly established BitFinex Securities.

Half of the funds raised from the sale of bonds will be used to build the Bitcoin City, and the other half will be used to buy Bitcoin. Therefore, half of the bond is "backed" by Bitcoin assets. These Bitcoins will be locked for five years, and the income from the future sale of these Bitcoins, in addition to the repayment of the principal, will be shared equally between the Salvadoran government and the bond buyers. In other words, if an investor buys a volcanic bond worth $100,000, assuming that the price of Bitcoin doubles in the future, it means that the investor can not only get an annual interest of 6.5%, but also half of the profit from investing in Bitcoin, which is another $25,000.

2. Volcano bonds have amazing interest rates

In an era of zero or negative interest rates, the interest rate on volcano bonds is attractive. With an annualized interest rate of 6.5%, the interest rate over 10 years can reach 146% through compounding. In contrast, the interest rate on US Treasury bonds, which are almost equivalent to cash, is [1.63%](1) for 10 years.

Of course, cheap things have their own reasons for being cheap. On July 30 this year, a well-known rating agency adjusted El Salvador's credit rating from [B3 to Caa1](2). This downgrade was partly due to El Salvador's "Bitcoin Act", and the Caa1 rating means that the bonds issued by El Salvador have been listed as "junk bonds". The so-called junk bonds refer to those with extremely high default risks. If a bond is rated as a junk bond, it will greatly restrict the entry of institutional funds.

The "Bitcoin City" is a city that is completely exempt from income tax, capital gains tax, property tax and personal tax. Its only source of tax is the 10% value-added tax. It can be imagined that the economy of the Bitcoin City must be quite developed for El Salvador to be able to pay the interest on the volcanic bonds through taxes.

3. “Volcano Bonds” are not a good product

In fact, there are a large number of El Salvador's treasury bonds that have not yet matured in the market, and the annual interest rate of 10-year treasury bonds is often as high as 13%. The reason why El Salvador can offer such a high interest rate is still because its default risk is extremely high.

Currently, the product on the market that is most similar to the "Volcano Bond" is a 10-year bond that will mature on April 10, 2032. The bond is listed on the Luxembourg Stock Exchange and has an annual interest rate of 8.25%, which is much higher than the Volcano Bond.

Not only that, this 10-year bond is much cheaper than the volcanic bond. Its current net value is 72.54 cents. That is to say, if investors are not worried about losing their principal, they can currently buy a bond of the same level (also issued by the Salvadoran government) with an interest rate much higher than the volcanic bond at a 28% discount.

However, the fact that half of the Volcano Bond is "backed" by Bitcoin makes it more speculative, because investors also have potential gains from the appreciation of Bitcoin. According to one of the partners of the Volcano Bond, Blockstream's Chief Strategy Officer, Miao Yongquan, the price of Bitcoin will reach US$1 million within five years.

If the price of Bitcoin can rise to 1 million USD within five years, there will be no problem in repaying the principal and interest of Volcano Bonds. However, the higher the price of Bitcoin rises, the harder it is to do so. In the past four years, it has only risen three times. If it is to reach 1 million USD in the next five years, it will need to rise nearly 20 times in a similar period.

Of course, it is not impossible for Bitcoin to rise to $1 million in five years, so investors will obviously consider another question: Why not buy Bitcoin directly? Someone has calculated that if Bitcoin really rises sharply, with the same $100,000, using $72,000 to buy $100,000 worth of El Salvador 10-year government bonds, and the remaining $28,000 to buy Bitcoin, the return is much higher than using all $100,000 in volcano bonds.

In other words, if volcanic bonds are considered a speculative product, their returns are not high enough; if they are considered a low-yield financial product, their risks are too high. According to [speculation](3) by Coindesk author Omkar Godbole, many countries with poor credit ratings find it difficult to borrow money from the market even if they offer very high interest rates.

In June this year, the International Monetary Fund (IMF) expressed opposition to El Salvador's adoption of Bitcoin as legal tender(4), so most people outside believed that it would be difficult for El Salvador to borrow money from the IMF. However, the truth is likely to be just the opposite: due to the deterioration of credit and political conditions over the years, Salvadoran President Nayib Bukele had already predicted that it would be difficult to borrow money from the IMF, so he came up with the "unique trick" of using Bitcoin as legal tender. The volcano bonds this time are also another unique trick that El Salvador has come up with to borrow money.

El Salvador’s target is still the whales of the crypto world, as the president said, ““You know there are a lot of whales on Bitfinex, so I think there is no problem filling a $1 billion bond.”