Wednesday, April 24, 2013

GDP-Indexed Bonds

Tyler Cowen outlined a number of hypotheses on why countries don't issue GDP-indexed bonds. It can be found here:  Marginal Revolution Why no gdp-indexed bonds? 

He had 5 hypotheses - Falsification, Adverse Selection, Existing CDS markets, Illiquidity of splitting a small country's bond market, and governments not running big budget surpluses in good times.

I have a sixth that I suspect may dominate all of the above: who are the investors? Banks, who I suspect are by far the largest purchasers of government bonds, tend to already have plenty of floating rate liquidity available to them on both the asset and liability sides (note that GDP-indexed and floating interest rate bonds should come close to comovement, unless you're basing it on real GDP, in which case all you're doing is stripping the inflation protection from floating rate bonds, which would be a substantively inferior product to what banks can get already and would thus require a discount). Individual investors who buy bonds tend to do so because they want the reliability of a fixed cash flow even (especially!) when GDP drops. And making products to sell to financial services firms (mutual funds and hedge funds) is not exactly a recipe for great pricing.

I am sure countries COULD sell GDP-indexed bonds, but how much worse would the terms be relative to a fixed rate?

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