Would You Buy a Bond Linked to Your Country’s GDP?

Imagine a sovereign bond that pays investors more when a country’s economy is doing nicely and less when gross domestic product is lagging. That’s the idea behind the GDP-linked bond, a seldom used debt instrument that is attracting increasing interest as authorities grapple with the extraordinary cost of the coronavirus pandemic.

1. What exactly is a GDP-linked bond?

When governments issue bonds to raise money, they pay investors a coupon typically in the form of interest at a fixed rate or tied to the inflation rate. But there’s another way: linking the coupon to economic growth. If a country’s economy grows strongly, it pays more in interest, and if it does badly, it pays less. Italy is aiming one such bond — called “BTP Futura” — at mom and pop investors to help finance its response to the coronavirus crisis. Interest rates will increase with time to reward savers. For those who hold the bonds to maturity, there’s a so-called “fidelity premium” tied to the nominal growth rate over the 10-year life of the bond.

2. What’s the advantage?

For countries experiencing economic pain, payments to bondholders would probably be lower than with conventional securities. Take Italy as an example. The economic shock resulting from weeks of lockdown caused its borrowing costs via conventional bonds to spike in March and April. With GDP-linked bonds, interest payments would instead fall as the country’s economy slowed, acting as a kind of counter-cyclical buffer and potentially reducing the need for austerity measures. For investors, such bonds amount to a bet on the economy not unlike — but lacking the volatility of — investing in equities.

3. What’s the downside?

There is a moral hazard risk. Countries that issue the securities may be more tempted to misreport growth figures, or even stifle economic growth policies, to avoid having to pay a higher rate of interest. Also, it’s not always clear whether investors in regular or growth-linked bonds would get their money back first in the event of default.

4. Who has tried them and how did that go?

Nobel laureate Robert Shiller is credited with first proposing the idea in the 1990s. Countries that have experimented with GDP-linked securities in some form have typically gone through an economic crisis. Costa Rica, Bulgaria and Bosnia and Herzegovina were among the first nations to issue such securities in the late 20th century, with Argentina and Greece trying them more recently. Hedge funds attemped to sue Argentina for allegedly manipulating its economic figures to avoid making payments on the bonds.

5. Where else are GDP-linked bonds getting attention?

A Bank of England researcher, writing in June, said that governments might reduce the cost of their debt burdens by using such instruments. An earlier United Nations report suggested that the bonds could be part of a more sustainable debt system in the future. It’s likely that a number of countries will be monitoring how Italy’s BTP Futura experiment fares.

6. Are there other alternatives?

With borrowing requirements soaring after many countries virtually shut down their economies to combat the pandemic, the need for creative ways to raise money is acute. For the European Union, billionaire hedge fund manager George Soros has touted the use of war-time like perpetual bonds, which never have to be repaid. The market is burgeoning for so-called green bonds to fund a recovery based on a shift to environmentally friendly infrastructure. Meantime, countries have switched to selling large amounts of debt via syndications, a costlier method than regular auctions but one that guarantees the bonds will find buyers.

The Reference Shelf

  • BusinessWeek on why pandemic bills are so big that only money-printing can pay them.
  • QuickTakes on coronabonds and syndicated bond sales.
  • A Bank of England blog on how to price GDP-linked bonds.
  • A UN brief on debt sustainability in the coronavirus age.
  • Shiller’s book: Macro Markets: Creating Institutions for Managing Society’s Largest Economic Risks.

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