The problem with GDP bonds

By Felix Salmon
August 3, 2009
Jonathan Ford thinks that GDP bonds are a good idea. I'm not so sure.

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Jonathan Ford thinks that GDP bonds are a good idea. What’s a GDP bond?

Imagine a country that normally grew its GDP at 5 percent a year. To the extent it grew at 6 percent, the coupon would be reset upwards by one percentage point. If it undershot by one percentage point, the interest rate would be similarly reduced.

Ford explains that this is good for both issuers and investors:

Most investors have three objectives: long-term growth; inflation protection and low price volatility… GDP bonds meet all three requirements…

For the issuer, GDP bonds also have appeal. As Willem Buiter has recently observed, they would give government debt some of the characteristics of an equity security. Their servicing costs would rise and fall in line with the state’s own ability to pay. This, Buiter observes, “would reduce the expansion of the public debt through the intrinsic debt dynamics that comes out of the product of the interest rate and the outstanding stock of debt.”

Ford and Buiter both worry about governments fiddling with macroeconomic statistics, but that’s actually the least of the problems here.

For one thing, although Ford and Buiter both point to Argentina as a precedent, there’s a big difference between what Argentina did and what they’re proposing. Argentina stapled detachable GDP warrants to its plain-vanilla bonds — they had upside, if GDP grew quickly, but no possible downside. Under this GDP bond scenario, by contrast, a bondholder could actually lose out by holding a GDP bond:

With $1 million worth of 10-year debt, for instance, there would be an amortisation of $100,000 each year, unless the growth rate of GDP that year were negative… With minus 2 percent GDP growth in year 1, interest payments would be minus 10,000, which could be paid as a reduction in principal repayments that year to $90,000.

Bond investors in general, and government bond investors in particular, are highly loss-averse — they’ll require much higher yields if there’s a real risk that they won’t be repaid their principal in full.

What’s more, bond investors valued those Argentine GDP warrants at zero when they were issued. If a detachable option with upside but no downside is valued at zero, then a built-in option with symmetrical upside and downside will clearly be valued at less than zero: the government is going to have to pay a big premium to complicate matters in this manner.

In general, it’s nearly always a bad idea to add optionality to bonds: it’s the kind of thing which seems very clever to investment bankers pitching deals, but which never really catches on among the buy-side.

With government bonds, the hurdles are even higher. Government bonds, after all, serve a dual purpose: they’re a mechanism allowing the government to borrow money, and they’re also the instrument by which the financial markets construct a benchmark yield curve. If GDP bond issuance were only a tiny proportion of the whole, like inflation-linked bonds are right now, then the upside for governments — lower interest expenses during recessions — would barely be noticeable. On the other hand, if they became the norm, then we would no longer be able to see at a glance what the risk-free rate of return was for any given maturity.

The fact is that while GDP bonds make a certain amount of sense in theory, they make no sense in practice. For the national treasury — a/k/a taxpayers — they will nearly always be more expensive than plain vanilla debt. At the same time, the fixed-income investors who tend to buy nearly all government debt want, well, a fixed income, not a variable dividend. If they wanted a variable dividend, they’d buy equities.

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