In finance, a GDP-linked bond is a

debt security A security is a tradable financial asset. The term commonly refers to any form of financial instrument, but its legal definition varies by jurisdiction. In some countries and languages people commonly use the term "security" to refer to any for ...

or derivative security in which the authorized issuer (a country) promises to pay a return, in addition to

amortization Amortization or amortisation may refer to: * The process by which loan principal decreases over the life of an amortizing loan * Amortization (accounting), the expensing of acquisition cost minus the residual value of intangible assets in a system ...

, that varies with the behavior of

Gross Domestic Product Gross domestic product (GDP) is a money, monetary Measurement in economics, measure of the market value of all the final goods and services produced and sold (not resold) in a specific time period by countries. Due to its complex and subjec ...

(GDP). This type of

security Security is protection from, or resilience against, potential harm (or other unwanted coercive change) caused by others, by restraining the freedom of others to act. Beneficiaries (technically referents) of security may be of persons and social ...

can be thought as a “stock on a country” in the sense that it has “

equity Equity may refer to: Finance, accounting and ownership * Equity (finance), ownership of assets that have liabilities attached to them ** Stock, equity based on original contributions of cash or other value to a business ** Home equity, the dif ...

-like” features. It pays more/less when the performance of the country is better/worse than expected. Nevertheless, it is substantially different from a stock because there are no ownership-rights over the country. GDP-linked bonds are a form of

floating-rate bond Floating rate notes (FRNs) are bonds that have a variable coupon, equal to a money market reference rate, like LIBOR or federal funds rate, plus a quoted spread (also known as quoted margin). The spread is a rate that remains constant. Almost all ...

with a coupon that is associated with the growth rate of a country, just as other floating-rate bonds are linked to

interest rates An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, th ...

, such as

LIBOR The London Inter-Bank Offered Rate is an interest-rate average calculated from estimates submitted by the leading banks in London. Each bank estimates what it would be charged were it to borrow from other banks. The resulting average rate is u ...

federal funds rate In the United States, the federal funds rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight on an uncollateralized basis. Reserve balances a ...

, or

inflation In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reductio ...

rates, which is the case of

inflation-indexed bonds Daily inflation-indexed bonds (also known as inflation-linked bonds or colloquially as linkers) are bonds where the principal is indexed to inflation or deflation on a daily basis. They are thus designed to hedge the inflation risk of a bond. Th ...

. These securities can be issued to reference real GDP, nominal GDP or aspects of both. In some cases, however, these securities may not have any principal claim and the notional is only used as a basis for calculating the investor's share of payments. The term GDP-linked bond is often used interchangeably with the terms

GDP-indexed bond In finance, a GDP-linked bond is a debt security or Derivative (finance), derivative security in which the authorized issuer (a country) promises to pay a return, in addition to amortizing loan, amortization, that varies with the behavior of Gross D ...

, GDP-linked security, and GDP-indexed security in the literature. Sometimes the term warrant is used as well. This is likely because it is a relatively new asset class in which there are few real examples—the few of which were created from restructurings rather than primary issuance. There is also a variety of different ways that these instruments can be structured. For example, they can take the form of equity-like securities where payments are solely contingent on GDP growth or another extreme where they can resemble vanilla bonds with adjustments based upon GDP performance. The country will designate the classification in the instrument's

indenture An indenture is a legal contract that reflects or covers a debt or purchase obligation. It specifically refers to two types of practices: in historical usage, an indentured servant status, and in modern usage, it is an instrument used for commercia ...

or prospectus.

Advantages for the issuer

Advantages for the issuer were reported as follows: Debt service varies with ability to pay. Therefore, if a country has poor economic performance, it needs to pay less on its obligations to the investors. This means that this type of security has

countercyclical Procyclical and countercyclical variables are variables that fluctuate in a way that is positively or negatively correlated with business cycle fluctuations in gross domestic product (GDP). The scope of the concept may differ between the context ...

features. The existence of this type of debt can reduce the

probability of default Probability of default (PD) is a financial term describing the likelihood of a default over a particular time horizon. It provides an estimate of the likelihood that a borrower will be unable to meet its debt obligations. PD is used in a variet ...

because they tend to keep the debt/GDP ratios within a narrower range than

fixed income Fixed income refers to any type of investment under which the borrower or issuer is obliged to make payments of a fixed amount on a fixed schedule. For example, the borrower may have to pay interest at a fixed rate once a year and repay the prin ...

bonds.Borensztein, Eduardo, and Paolo Mauro (2004). "The Case for GDP-indexed Bonds." Economic Policy 19 (38): 166-216. GDP-linked bonds also act as

automatic stabilizers In macroeconomics, automatic stabilizers are features of the structure of modern government budgets, particularly income taxes and welfare spending, that act to damp out fluctuations in real GDP. The size of the government budget deficit tends to ...

and reduce the temptation for

policymakers Policy is a deliberate system of guidelines to guide decisions and achieve rational outcomes. A policy is a statement of intent and is implemented as a procedure or protocol. Policies are generally adopted by a governance body within an organ ...

to spend too much in periods of high growth. In this sense this type of bond may be especially useful for developing countries where the presence of weaker

institutions Institutions are humanly devised structures of rules and norms that shape and constrain individual behavior. All definitions of institutions generally entail that there is a level of persistence and continuity. Laws, rules, social conventions a ...

makes it easier for governments to implement more volatile policies. Moreover, this type of bond allows governments to implement less volatile tax policies, since there is less need to increase taxes during times of poor economic performance because it is precisely during these times when debt repayments are lower. If we believe that agents prefer to smooth consumption across time and across states of nature then it is worth it to do so. Hence using GDP-linked bonds may be

welfare Welfare, or commonly social welfare, is a type of government support intended to ensure that members of a society can meet basic human needs such as food and shelter. Social security may either be synonymous with welfare, or refer specificall ...

improving. Furthermore,

emerging markets An emerging market (or an emerging country or an emerging economy) is a market that has some characteristics of a developed market, but does not fully meet its standards. This includes markets that may become developed markets in the future or were ...

are usually forced to actually undertake more austere measures in times of

crises A crisis ( : crises; : critical) is either any event or period that will (or might) lead to an unstable and dangerous situation affecting an individual, group, or all of society. Crises are negative changes in the human or environmental affair ...

than their developed counterparts, and it is common to see that emerging markets reduce public expenditures in times of crises with the purpose of reassuring international investors. This means that countries cut their expenditures when they need it the most. In terms of

social policy Social policy is a plan or action of government or institutional agencies which aim to improve or reform society. Some professionals and universities consider social policy a subset of public policy, while other practitioners characterize soci ...

it has been mentioned that GDP-linked bonds disproportionately benefit the poor because using them reduces the need to cut

social benefits Welfare, or commonly social welfare, is a type of government support intended to ensure that members of a society can meet Basic needs, basic human needs such as food and shelter. Social security may either be synonymous with welfare, or refe ...

when economic performance is low, given that the debt repayments are lower. For a corporate issuer or project finance issuer whose revenues will be driven by (amongst other things) GDP, to issue GDP-linked debt would leave the overall capital structure less risky. Finally, even if this type of bond were initially thought in the context of emerging markets, they also constitute an interesting idea for developed countries.

Advantages for the investor

For an investor who wants to purchase an income stream that rises with average incomes, but does not want the volatility of the stock market, they could be attractive. A

committee A committee or commission is a body of one or more persons subordinate to a deliberative assembly. A committee is not itself considered to be a form of assembly. Usually, the assembly sends matters into a committee as a way to explore them more ...

in the UK which looked at where people would ideally save, concluded that ideal pensions would be linked to average incomes prior to retirement and to inflation after retirement. These instruments also provide an investor with the opportunity to speculate on a country's increase in GDP if they have a more favorable view of the country's prospects relative to other market participants.

Disadvantages for the issuer

GDP-linked bonds may cause

political economy Political economy is the study of how Macroeconomics, economic systems (e.g. Marketplace, markets and Economy, national economies) and Politics, political systems (e.g. law, Institution, institutions, government) are linked. Widely studied ph ...

problems, in good times countries have to pay more to their

debt Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to another party, the creditor. Debt is a deferred payment, or series of payments, which differentiates it from an immediate purchase. The ...

holders, so citizens can potentially complain arguing that the governors contracted debt to favor the lenders. Another reason to worry about the characteristics of these bonds is that they may create

perverse incentive A perverse incentive is an incentive that has an unintended and undesirable result that is contrary to the intentions of its designers. The cobra effect is the most direct kind of perverse incentive, typically because the incentive unintentionall ...

s (

moral hazard In economics, a moral hazard is a situation where an economic actor has an incentive to increase its exposure to risk because it does not bear the full costs of that risk. For example, when a corporation is insured, it may take on higher risk ...

) to misreport growth, not revise GDP figures or even worse to repress growth. An additional critique that has been exposed is that there are other debt instruments that could be superior in the task of insuring

risk In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value (such as health, well-being, wealth, property or the environme ...

for

consumer A consumer is a person or a group who intends to order, or uses purchased goods, products, or services primarily for personal, social, family, household and similar needs, who is not directly related to entrepreneurial or business activities. T ...

s. That is, for example, the case of CPI-indexed local currency bonds.

Crises A crisis ( : crises; : critical) is either any event or period that will (or might) lead to an unstable and dangerous situation affecting an individual, group, or all of society. Crises are negative changes in the human or environmental affair ...

are generally accompanied by large

exchange rate In finance, an exchange rate is the rate at which one currency will be exchanged for another currency. Currencies are most commonly national currencies, but may be sub-national as in the case of Hong Kong or supra-national as in the case of ...

depreciations that are driven by the fall in

domestic consumption Consumption is the act of using resources to satisfy current needs and wants. It is seen in contrast to investing, which is spending for acquisition of ''future'' income. Consumption is a major concept in economics and is also studied in many o ...

. This fall in consumption decelerates the CPI growth and in turn bonds linked to it pay less during crisis. Given that economic agents are more interested in

consumption smoothing Consumption smoothing is an economic concept for the practice of optimizing a person's standard of living through an appropriate balance between savings and consumption over time. An optimal consumption rate should be relatively similar at each stag ...

than in the stabilization of output, CPI-indexed local currency bonds may provide a better insurance against shocks than GDP-linked bonds. However, these types of bonds do not allow direct exposure to real GDP growth and only permit investors to smooth out consumption if they have a natural exposure to the CPI of the nation—such as citizens of the nation.

Disadvantages for the investor

There may not be a sufficient number of participants to issue and invest in this type of security. The market has not developed in part because there are few

incentive In general, incentives are anything that persuade a person to alter their behaviour. It is emphasised that incentives matter by the basic law of economists and the laws of behaviour, which state that higher incentives amount to greater levels of ...

s to be the first to move. Being one of the initiators in this type of market implies taking risks and undergoing a learning process that many agents are not incentivized to do. Also, more countries need to issue these types of securities so that

investor An investor is a person who allocates financial capital with the expectation of a future Return on capital, return (profit) or to gain an advantage (interest). Through this allocated capital most of the time the investor purchases some specie ...

s are able to diversify. Given these facts, there is scope for public intervention. For example, an initiative from multilateral institutions could play the role of first mover and coordinate issuances of GDP-linked bonds from different countries. There may, thus, be a discount reflecting illiquidity. These securities introduce investors to new forms of risks different from other sovereign instruments. Investors are exposed to the country's GDP level and growth path which may or may not be favorable. Moreover, investors may be at the mercy of the issuing country honesty with respect to economic data. The methodology for valuing these securities is also somewhat complex as these are akin to financial derivatives. Lastly, the ranking of these instruments in the case of a debt default may not be favorable as these are equity-like instruments which, as in the recent Greece and Argentina GDP linked securities, have no legal principal claim.

Historical background

Previous to the actual issuance of GDP-linked bonds, there were some financial innovations that lead to the appearance of bonds that had features related to the economic performance of the issuing country. Mexico issued several bonds indexed to oil prices during the 1970s and later on, in the early 1990s, Mexico, Nigeria, Uruguay and Venezuela issued some Brady bonds with Value Recovery Rights (VRR), that were structured to pay higher returns when the price of certain commodities was sufficiently high. The first pure GDP-linked bonds were issued by Costa Rica, Bulgaria and Bosnia Herzegovina, also in the context of the Brady restructuring agreements, in the 1990s. Greece and Argentina issued warrant-like instruments with some similarities to GDP-linked bonds as part of their recent restructurings in 2012 and 2005 respectively. Argentina issued a GDP-linked instrument in 2002, as part of a debt-restructuring of its 2001 default. Argentina's GDP-linked instrument was issued in exchange for debt that the investors forgave in the debt default. It did not take the form of a bond, however, as it did not have any principal due associated with it. The annual dividends of the instrument can allow the investor to recoup up to 48% of the notional of the instrument provided that Argentina's GDP growth exceeded certain benchmarks over 30 years. Greece issued a GDP-linked instrument as part of its debt default in 2012 somewhat similar to a GDP-linked bond. Under the terms of the Greek security, investors can receive only up to 1% of their notional in a given year provided that a number of conditions are met. Payments on Greece warrants, moreover, are based on a formula that only considers Greece's growth rather than the level of Greece's GDP. Finally, the payment obligations on the GDP-linked securities require Greece's GDP to attain certain levels and GDP forecasts have been falling for Greece. The Greece GDP warrants are not technically bonds as investors do not have any principal claim against the government of Greece in the event of a default.

A simple example

Suppose a country has been growing in the last few years at an average rate of 3% and is expected to do so in the coming years. Suppose also that this country can issue debt using a fixed-income bond with a coupon of 7%. This country can issue a GDP-linked bond that pays 7% when output growth at the end of the year is exactly 3% and will pay more or less accordingly to its economic performance. That is, for example, if the country grows 1% instead of 3%, then the GDP-linked bond will pay a coupon of 5% instead of 7%. Conversely, if there is an unusually better economic performance and the country grows 5% instead of 3%, then the GDP-linked bond will pay a coupon of 9%.

References

{{DEFAULTSORT:Gdp-Linked Bond Government bonds