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People and MarketsCommentGC View

Leave GDP-linked bonds to the academics

As Greece nears a deal on a third bail-out package, the idea of GDP-linked sovereign bonds will bubble up again. The structure looks good in academic papers, but the real world might be less forgiving.

The use of GDP-linked bonds to help Greece deal with its debt burden has been championed by former Greek finance minister Yanis Varoufakis as well as several economists and analysts.

By increasing coupon payments at times of growth and decreasing them during times of stress, proponents of the structure argue that GDP-linkers allow investors to buy into the future of a country, while issuers lower their debt service costs when times are tough.

But some proponents of the idea have gone even further, suggesting that the whole sovereign market should adopt GDP-linked bonds.

Fine in theory, but why would countries whose bond markets are in perfect shape be willing to suffer the cost and disruption of switching to a new model? Particularly, as this would be far from a quick switch. 

For instance, at the end of July, Italy had €1.848tr of bonds outstanding — the highest level in the eurozone — at an average tenor of 6.48 years. Around €90bn of that paper does not start maturing until the 2040s.

Introducing GDP-linked bonds as a new standard would mean there would be a two-tiered secondary market in government bonds for a long, long time.

That, coupled with the new practices and conventions that would be required to price GDP-linked bonds, could also create knock-on effects in markets beyond governments.

Would a GDP-linked sovereign bond still be a rates product? If not, would it cease to be a benchmark for pricing other bonds? There would certainly need to be a long adjustment phase.

And there is also the question of just where the data on GDP would come from.

In a paper on GDP-linked bonds published last month — which talked simply of the use of GDP-linked bonds, rather than their replacing of conventional sovereign bonds — Stephen Park of the University of Connecticut School of Business and Tim Samples of the University of Georgia’s Terry College of Business suggest that organisations such as the International Monetary Fund, World Bank and regional development banks could verify macroeconomic data and underwrite GDP-linked securities.

Having these bodies provide the data might bolster investors’ confidence, but it would raise questions over the sovereignty of sovereign bonds.

Even in countries which are in dire need of international bail-outs , such as Greece, there is strong opposition to outside agencies poking their noses in — if GDP-linked bonds were introduced across the board, national governments in rude financial health are unlikely to be too happy if the size of their coupon payments are dependent on growth estimates that might disagree with those of their internal agencies.

And that is before factoring in the common practice of revising GDP figures several months after they are released.

Would that mean coupon payments may have to be dragged back from investors if, a few months down the line, it turned out a country’s GDP had gone down rather than up?

Attempting to address some of the weaknesses of the global sovereign bond market through innovative means like GDP-linked bonds should be applauded.

But there is still a lot of work to be done to remove all the potential problems — and it would be a brave debt management office that decides to be the first to test the format.