Issuing GDP-linked bonds

Abstract

This paper compares supply and demand to assess to what extent there can be a market for GDP-linked bonds (GLBs). For the government side, simulations illustrate the debt-stabilisation property of GLBs. These simulations consider shock persistence with a VAR structure and large events with shocks drawn from the residuals. Countries where shock persistence and the standard deviation of the interest rate – growth rate differential scaled with the debt level are higher reap more benefits from GLBs and hence can accept a larger risk premium on GLBs. For the investors’ side, risk premia compensating for GDP volatility are calculated with a CAPM, considering not only the size of growth shocks and their correlation with market prices, but also their persistence. Calculations are made with simplifying assumptions going against the case of GLBs: in particular, the possible reduction in the default risk premium is ignored. Even so, both high-risk and low-risk countries can benefit from GLBs: the ones that have to pay a larger risk premium are those that need this insurance against debt crises the most.