Bearer bonds: opportunities and risks in perfect balance

Bearer bonds explained, what to bear in mind when trading them and how they can be applied to improve your portfolio

To most private investors, trading securities on the stock exchange means trading stocks and bonds. In recent years, ETFs (exchange-traded funds), as well as ETCs (exchange-traded commodities) have also become increasingly popular.

Equity and index funds are based on shares, while bonds, certificates and ETCs are bearer bonds. To a large number of investors, they offer access to markets not covered by shares, such as the currency and commodity markets.

In this piece, we will look at the basic characteristics of bearer bonds as well as their various trading forms and issuers. Finally, we will highlight the benefits and downsides of bearer bond investments, and illustrate them with an example.

What is a bearer bond?

Also referred to as bond, fixed-interest security or debenture bond – legally speaking, a bond is a security, i.e. a securitised claim of the creditor against another party such as a company or a state as debtor, to allow the debtor to raise funds in another way than via a bank loan. The acquirer of a bond does, as a rule, not become a shareholder of the issuer, as is the case when buying stocks. Rather, the buyer’s role is usually limited to that of a lender. In return, the investor receives a variable or fixed interest rate, the amount or specification of which is precisely defined in the terms of the bond prospectus, as are the security’s term and the redemption modalities at the end of the term. Generally speaking, there are two types of bonds: Registered bonds and bearer bonds. Both are securities, but while the former are issued in the name of the creditor defined in the bond, bearer bonds are not issued to a specific creditor, but transferable at will – the respective acquirer becomes the respective holder with all securitised rights and obligations. This transferability is an essential prerequisite to allow for a bond’s fungibility and thus its high marketability, which is necessary for exchange trading. Today, the securitisation of a bearer bond usually occurs via so-called collective certificates. Physical delivery is ruled out as there is generally no claim to individual securitisation, which would also be highly impractical in exchange trading. When purchasing a bearer bond, investors thus receive a deposit credit documenting the transfer of ownership.

Who can issue bearer bonds?

States (such as the German Federal Government), federal states (such as the German Bundesländer) as well as companies, e.g. from the banking, manufacturing, transport and trade sectors, may act as issuers of bearer bonds. Public bearer bonds issued by EU and EEA member states and Bundesländer in the form of bonds are automatically admitted to exchange trading at every German domestic stock exchange.

What are the types of bearer bonds traded?

Investors tend to be familiar with more bearer bonds than they are aware of: public bonds, often called government bonds, and corporate bonds are usually bearer bonds. There are exceptions, i.e. products which cannot be traded on the stock exchange. Convertible bonds, medium-term notes, certificates and ETCs are also bearer bonds.

The following forms of debt securities are not categorised as bearer bonds: savings bank bonds are so-called order bonds, a special type of bond issued in the name of a specific creditor but allowing the creditor and subsequent buyers to transfer the bond to others. Savings bonds and savings bank bonds, on the other hand, are usually issued as registered bonds, while German “Pfandbriefe” can be issued as bearer, registered and order bonds.

What are the advantages of bearer bonds for investors?

Bearer bonds allow investors to lend money to a company and get it back after the agreed term with a guaranteed interest rate, to track the price of a share with a certain leverage (for example 10) or to invest in commodities such as coffee or crude oil – on the stock exchange, equally liquid and transparent as shares or ETFs. Some bearer bonds are deemed especially safe forms of investment, such as German government bonds. Most industrialised nations’ bonds as well as a number of corporate bonds are also considered comparatively safe. The decisive factor, however, is not the fact that the instruments are bearer bonds, but rather the creditworthiness of the respective issuer – regardless of whether it is a state or a company. Before making an investment decision, investors should, therefore, always be sure to gather accurate information on the creditworthiness of the company in question. The same applies to government bonds, especially for those of emerging markets. Interest rate levels are generally an excellent indicator of debtors’ creditworthiness, i.e. of investment risk: the higher the interest rate, the greater the issuer risk. Bearer bonds can also be high-risk investments. This is true for turbo certificates, which can give a leverage of 10, for example, to price changes in the underlying share or other security, thus increasing the effects of price changes tenfold. Disproportionately high gains can thus be achieved when the price rises, but the risk of loss also increases accordingly.

What are the downsides of bearer bonds?

Investors vividly remember the horrifying financial crisis a decade ago, and the ensuing insolvency of US investment bank Lehman Brothers. In total, investors lost more than €1 billion. This was due to bearer bonds, in this particular case certificates, which were not or insufficiently secured. The so-called issuer risk had become bitter reality, because issuers may become insolvent and bearer bonds are not covered by deposit insurance. In this case, investors may lose all their invested capital. Issuers usually hedge by means of various measures, for example via physical asset backups or through swaps, all of which in effect do not actually provide 100 per cent protection in a real-case scenario. A further risk is posed by bearer bonds with variable interest rates, e.g. based on key interest rates, if they develop differently than expected. In such cases, investors may only get their initially invested money back.        

Bearer bonds in practice: Xetra-Gold

The ETC Xetra-Gold is a bearer bond with no maturity limit. Each unit of Xetra-Gold (i.e. one bearer bond) is backed by one gram of gold with a fineness of 999.9, purchased at wholesale price. This gives investors the opportunity of trading gold flexibly and transparently on the stock exchange. In addition, Xetra-Gold is highly cost-efficient, as investors benefit from significantly lower trading margins compared to the purchase or sale of physical gold. It also spares them the effort and costs of storage. The disadvantage is the issuer risk typical for bearer bonds. In order to reduce this risk, the issuer Deutsche Börse Commodities holds one unit of physical gold in custody on the issuer’s behalf for each unit of Xetra-Gold in circulation. Just like physical gold, Xetra-Gold does not offer any interest. Rather, it securitises the right to delivery of physical gold at any time in the amount corresponding to the investor’s Xetra-Gold investment.

What type of investor are bearer bonds suitable for?

The range of bearer bonds is enormous. Government bonds of industrialised countries and selected large company bonds can be suitable hedging instruments for a portfolio. Much riskier bearer bonds in the form of certificates and ETCs as well as emerging market and high-yield bonds can serve as potential yield drivers within a portfolio. Depending on the structure, this type of investment can meet the needs of conservative investors as well as of those more willing to take risks. However, there is one thing that all investors, however venturesome, should definitely keep in mind: bearer bonds involve an issuer risk. Before making an investment decision, investors should therefore always critically examine the issuer’s creditworthiness and the type of bearer note.