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.

Comments
5 comments so far

“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.”

Isn’t it fixed, as up against a benchmark that matters if you want to retain the value of your money?

I’m just wondering if the problem is that these GDP Bonds would be less useful for trading purposes, so that nobody has a real incentive to market them.

“The fact is that while GDP bonds make a certain amount of sense in theory, they make no sense in practice”

Doesn’t this mean that the marketers of these products wouldn’t make enough money on them?

Again, I don’t know. However, I’m always interested in cases where an idea makes senses in theory, but not in practice. I don’t want to go over all the issues, but couldn’t you stand to lose much more on fixed rate bonds? And the govt has plenty of ways to screw you with bonds if it suits their purposes. This seems like a good product, but not a lucrative one for anyone other than the buyer and, hopefully, the govt. But bonds confuse me.

I think Felix misses part of the point of these bonds. Of course they’re more expensive, they’re riskier. But right now that risk is borne by the taxpayers and citizens of the borrowing country. In a crisis, these people face harsh austerity measures. A GDP bond is a means of transferring some of that risk to lenders. Naturally they will have to be paid to bear the risk. The fact that it costs more to borrow with this instrument is good since it will encourage govts to live within their means and at the same time shield their citizens from some risk. It’s an alternative to outright default. Barry Eichengreen at UC Berkeley has done some research on putting work-out provisions into sovereign debt issues that you might be interested in.

Posted by dcreader | Report as abusive

I’m a bit confused… what exactly is is the recommendation? There are two arguments:
[a] Governments with established, highly-rated treasuries should sell GDP bonds
[b] Bonds issued by governments with a non-trivial default probability should issue GDB bonds

The arguments that you offer are pretty convincing that countries in group [a] like the UK and USA (listed in the lede of the linked article) do little service to themselves or their investors with such a product.

I’m not sure I’m convinced either way regarding countries in group [b]. Are the bulk of investors in the debt of the nations listed in the body of the article as concerned about consistent coupons? And a risk-free yield curve would need to be approximated anyhow… possibly using forex rates and the US yield curve (right?).

Posted by Jordan | Report as abusive

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