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 monetary 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 subjective nature this measure is oft ...
(GDP). This type of
security" \n\n\nsecurity.txt is a proposed standard for websites' security information that is meant to allow security researchers to easily report security vulnerabilities. The standard prescribes a text file called \"security.txt\" in the well known locat ...
can be thought as a “stock on a country” in the sense that it has “
equity-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 al ...
with a coupon that is associated with the
growth rate of a country, just as other floating-rate bonds are linked to
interest rates, 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 ...
or
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 reduct ...
rates, which is the case of
inflation-indexed bonds. 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 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 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 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 specifical ...
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 wer ...
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 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 human needs such as food and shelter. Social security may either be synonymous with welfare, or refer specifical ...
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 economic systems (e.g. markets and national economies) and political systems (e.g. law, institutions, government) are linked. Widely studied phenomena within the discipline are systems such as labour ...
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 unintentional ...
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 environm ...
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. ...
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 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 (profit) or to gain an advantage (interest). Through this allocated capital most of the time the investor purchases some species of property. Type ...
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%.
Categories
Shiller
[Shiller, Robert (2005a). "In Favour of Growth-Linked Bonds." The Indian Express. March 10. Shiller, Robert (2005b). In Inge Kaul and Pedro Conceicao ds The New Public Finance, Responding to Global Challenges. New York: Oxford University Press.] method: The value of the instrument depends on the value of GDP
Borensztein and Mauro:
The return varies with the growth rate of real GDP
See also
*
Bond (finance)
In finance, a bond is a type of security under which the issuer ( debtor) owes the holder ( creditor) a debt, and is obliged – depending on the terms – to repay the principal (i.e. amount borrowed) of the bond at the maturity date as well a ...
*
Common stock
Common stock is a form of corporate equity ownership, a type of security. The terms voting share and ordinary share are also used frequently outside of the United States. They are known as equity shares or ordinary shares in the UK and other Comm ...
*
Derivative (finance)
*
Equity
*
Inflation-indexed bonds
*
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 al ...
*
Warrant (finance)
In finance, a warrant is a security that entitles the holder to buy or sell stock, typically the stock of the issuing company, at a fixed price called the exercise price.
Warrants and options are similar in that the two contractual financia ...
References
{{DEFAULTSORT:Gdp-Linked Bond
Government bonds