The Volcano Bond is Nuts. It Might Sell Out Anyways.
It's success depends on what buyers care about...
Remember Nayib Bukele? He sports a leather jacket and a backwards cap. He buys bitcoin naked from his cellphone. He lost millions day-trading and changed his profile picture to an image of himself in a MacDonalds uniform, in reference to the popular meme about flipping burgers after losing it all. He made bitcoin legal tender and sometimes tweets from his official government account wRiTinG LiKe tHiS.
He is also president of El Salvador.
Needless to say, traditional finance investors are disturbed. Not just by the memes, but also by his takeover of the judiciary system, the fiscal voracity of his government and the rocky relations with the IMF. The country is rated “junk” by all three rating-agencies and is shut out of financial markets, which is alarming consdiering there’s an 800-million-dollar bond due next January.
In these conditions, Bukele can’t raise fresh money to rollover existing debts, not unless El Salvador pays exorbitant and self-harming interest rates of 15-20%. That’s why markets think he is likely to start missing debt payments in the next few years.
Instead of confronting these problems, Bukele’s government is moving forward with plans to issue a very exotic ten-year, billion-dollar bond with crypto firms Blockstream and iFinex.
What are the funds for?
Half the funds from the issue, 500 million dollars, will be used to buy bitcoin. Of course, this is highly unusual for a country, particularly in the context of acute financial distress and likely debt default.
Buying bitcoin with a taxpayer money is already risky but buying bitcoin with borrowed money is even more risky because it vastly amplifies the upside and downside scenarios. Buying bitcoin on pure leverage is appropriate for hedge funds, not a sovereign government that needs stability and a clear path out of the financial hole…
The other 500 million dollars are supposed to finance new infrastructure projects that seem relatively half-baked and aren’t properly planned or budgeted yet. These include a so-called bitcoin city powered by geothermal energy from a volcano. Hence the name volcano bond.
Funding infrastructure with debt is common, especially if the public works enable new types of economic activity, grow the pie and generate jobs and tax revenue. But this bitcoin city project seems awfully improvised and tangential to El Salvador’s pressing economic issues. It’s also coming at a time when the government should be trimming expenditures and focusing on debt sustainability, not talking up new spending commitments.
How is the volcano bond structured?
So far, all we know is that the bond will pay 6.5% annual interest in USD or the Tether stablecoin USDT. It will also pay half of the appreciation on the bitcoin (if there is any) in years five to ten, also in USD or equivalents.
In this sense, the volcano bond is an unusual combination of two different instruments. First, a vanilla fixed income instrument, which is typically attractive to retirees and pension funds because it provides reliable income over a known time period.
Second, there’s the payments on years six to ten if the $500 million in bitcoin appreciates, which most closely resemble a series of call options on bitcoin (with a strike price equal to the average price of the initial $500 million purchase). They resemble call options because the variable payouts rise as BTC appreciates but are zero if bitcoin remains stable or deppreciates.
Is this enticing for traditional bond investors?
Not by a mile. For starters, the volcano bond will be very volatile since it will be priced as the sum of the vanilla bond and the (quasi) call options on bitcoin, which are extremely volatile.
If you buy bitcoin and the price falls 20%, you still have 80% of your money but if you buy a call on bitcoin and BTC falls 20%, you lose much more, sometimes the entire investment, depending on how much time is left on the option. Hence the volatility of option contracts.
Wild price swings on the volcano bond will be a big turnoff for most if not all traditional bond investors that just want to live off of their annual interest payments and not risk cardiac arrest whenever they check their investment portfolio.
Also, the legal jurisdiction is wrong. All of El Salvador’s currently outstanding international bonds are governed by New York law. That means that if El Salvador’s government doesn’t pay, you can sue them in a New York court with a New York judge.
However, the apparent plan is for the volcano bond to be governed by local El Salvador law. So, if your Volcano bond isn’t paid, you have to sue El Salvador’s government in El Salvador. That doesn’t sound great, considering Bukele packed the supreme court with political loyalists last May. Good luck with any disputes!
What happens if El Salvador stops paying its debts?
Markets think there’s about an even chance Bukele defaults within a year, so this is an extremely relevant question.
It’s also very complex, because it depends on (a) which bonds default, (b) whether a default on the volcano bond triggers default on the regular New York law bonds and vice versa, (c) what bondholders (if any) have a claim on the $500 million in bitcoin Bukele plans on buying and (d) how enforceable that claim is (if at all).
Default could play out in a million ways because all we know about the volcano bond is from a powerpoint slide and scattered statements. But let’s do some hypotheticals. Suppose El Salvador defaults on all its bonds (including the volcano) in three years and that bitcoin has quadrupled to $200,000 from about $50,000 today (rounding up).
In this scenario, can volcano bondholders break open the BTC piggybank, sell some BTC and recover the par value of their fixed income investment? If so, what happens to the quasi call options? Do they become void? Importantly, can non-volcano bondholders also take some BTC to get paid if there’s any leftover from the volcano bondholders?
Who has the “keys” to the “wallet” with the bitcoin anyways? Is it some trusted third party? Or will Bukele have the keys? In any case, the details matter for the valuation and risk profile of the instrument, and so far they don’t look good…
Can the Volcano bond sell out anyways?
Absolutely. The market cap of all crypto is about $2 trillion, and Bukele is only looking to raise a single billion dollars. That’s 0.05% of the total. If Bukele can convince a twentieth of one percent of crypto that the volcano bond is a good deal on the merits or advances crypto adoption and legitimacy, he will sell the bond and raise the billion dollars.
We’ve seen it happen time and again these past two years. Redditors from wallstreetbets and crypto “degens” don't care much for plans, risks and the general seriousness of things. They’ll buy gamestop stock for over $100. They’ll buy straightforward ponzi-coins and shares in Trump’s SPAC that has no business plan. They’ll buy governance tokens for constitution DAO, even after it fails to buy a copy of the constitution.
Bukele is selling to that demographic, and he isn’t selling a “bond” with BTC “quasi call options” attached. He is selling the aesthetic of volcano powered bitcoin mining. He’s selling the FiRsT eVeR sOvEReiGn bItCoiN bond. He’s selling a cultural artefact that will have eNdUriNg hIsToRiCaL vAluE. He is selling a moment. A mood.
Are there a billion dollars worth of buyers? My guess is probably yes.
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