Bearer bonds, also called coupon bonds, are an unregistered bond -- ownership is determined by possession. No records are kept of the owner, and all transactions are purely anonymous. If you own the paper certificate, then you own the bond -- it's as simple as that.
Bearer bonds helped define many common terms in the world of bonds today. For instance, a bond's "coupon" is its interest payment. This term came from the fact that paper bearer bonds had "coupons" that were to be clipped and redeemed for the interest payment. In the picture above, notice the four strips on the right of the bond. These were the coupons which had to be redeemed for interest due on the bond.
The decline of bearer bonds in the United States
Bearer bonds were eventually made obsolete in the United States as part of the Tax Equity and Fiscal Responsibility Act of 1982. The Act did not specifically outlaw the bonds, but it removed the tax deduction for the interest paid by the issuer. It also required the issuer of bearer securities to pay an excise tax of 1% of the principal value multiplied by the years to maturity. Thus, the issuer of $100 million of bonds set to mature in 20 years would have to pay $20 million in excise taxes to issue a new bearer security, and any interest paid on the bond would not be tax deductible, unlike a registered bond.
At a tax rate of 35%, registered bonds yielding 5% would effectively cost 3.3% in after-tax interest expenses. The same debt issued as a bearer bond would cost 5% after tax, since the interest would not be tax deductible. Any rational borrower would prefer to pay 3.3% in annual after-tax interest rather than 5%, plus up-front excise taxes, and thus the issuance of bearer securities came to an abrupt halt.
The government had incentive to curtail the use of bearer bonds. Completely anonymous and available in big denominations, they had become the currency of choice for money launderers, tax evaders, and criminals. Bearer bonds' reputation as being a product for tax cheats hasn't changed much. In 2015, Switzerland-based UBS faced allegations for helping wealthy Americans avoid taxes with bearer securities.
Although you'll probably never encounter a bearer bond in the United States, they remain popular abroad. Eurobonds -- bonds issued in a foreign currency -- are typically issued as bearer bonds, as they are exempt from the United States' taxation policies. However, as time goes on, financial markets shift to electronic record keeping, and governments crackdown on tax avoidance, it's likely that bearer bonds will eventually go the way of the dinosaur.
Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.