1 Jan 0001

Giving investors a Trill

GDP-linked bonds could offer a more flexible way for governments to borrow money than the time-worn sovereign bond. It’s time they were given a chance, says Christopher Alkan

The way governments raise cash has changed little in hundreds of years. While companies and individuals have a host of options for getting their hands on extra funds, countries have stuck doggedly to the old-fashioned sovereign bond. 

Yet as nations across the world get deeper into debt the drawbacks of this time-worn security are becoming ever more obvious. Their key shortcoming is that interest must be paid come what may. Economic growth may plunge and tax revenues may slide but bond investors will demand exactly the same coupon payment regardless.

Companies typically finance their operations through a combination of debt and equity. As a result they can cut back dividend payments when times get tough

Robert Shiller, Yale economist

Governments from Greece to Lithuania are increasingly suffering from this inflexibility, and are cutting back spending or raising taxes precisely when their economies are most vulnerable. 

Most government officials see no alternative to these fixed-income instruments, but the more adventurous mandarins and economists are increasingly interested in the possibility of GDP-linked bonds. Greece recently experimented with these securities, which pay investors more when economic growth is strong and scale back coupons when times are tough. 

So far such innovative securities have only been issued as a last resort by insolvent nations such as Greece and Argentina. But senior officials in the US and Britain have been considering issuing similar bonds. Heavyweight Yale economist Robert Shiller has become an evangelist for these bonds, which he calls Trills because his version of the bond would pay out a trillionth of GDP per year.

Shiller, who gained fame by anticipating both the 2000 stock market crash and the bursting of the housing bubble, believes that such bonds could  help nations cope with rising debt levels while offering investors an exciting new product. 

Breathing space

The potential advantages for governments – and their citizens – are obvious. “Companies typically finance their operations through a combination of debt and equity,” Shiller says. As a result they can cut back dividend payments when times get tough. Nations, which are financed exclusively by debt, don’t have this luxury. Trills would function like “equity for countries”, giving governments more financial breathing space during economic downturns. 

On the most basic level, this would make it much easier for governments to engage in Keynesian fiscal policy – attempting to put more money in the hands of its citizens during economic slumps.

“The biggest problem with traditional government bonds is that they force governments to keep paying the same interest even when tax revenues decline sharply and the need to pay out unemployment and other benefits soars,” says Marc Chandler, a top strategist at New York investment bank Brown Brothers Harriman.

“The dilemma is especially acute for developing countries that are not always able to borrow new funds easily. As a result they are often compelled to raise taxes and cut back spending at the worst possible time.” 

Even richer countries experience a milder version of this dilemma. With the US deficit at $1.3trn in 2011 – more than 8% of GDP – pressure has mounted for immediate spending cuts and tax increases.  The US government doled out $454bn in interest payments in 2011, up from $352bn in 2005; a curse for taxpayers at a time when economic growth has slowed down sharply. 

A GDP-linked bond would limit this problem in the following way. Imagine a country with an average growth rate of 3% that is able to borrow money at 7%. A GDP-linked bond could be issued that would pay 1% above or below 7% for every one percentage point that growth exceeds or falls short of 3%. 

Of course, GDP bonds wouldn’t totally eliminate fiscal pain. Take Greece. The nation’s GDP fell by 7.4% in 2010. Had Greece issued only GDP bonds, its debt repayments would have fallen – but not nearly enough to have prevented serious financial stresses. After all, Greek creditors recently had to accept a 53% haircut on their bonds. Even so, such bonds can make a big difference. Had half Mexico’s debt consisted of Trills when it was hit by a financial crisis in 1995, it would have saved about 1.6% of GDP in interest payments, according to data presented in a United Nations study. 

“These additional resources would have provided the government with space to avoid sharp spending cuts and would have maybe even provided some leeway for additional spending that may have mitigated some of the worst effects of the crisis,” says Stephany Griffith-Jones, an economics professor at Columbia University in New York, who worked as an adviser to the United Nations.

This can be especially good news for the poorest members of society, who typically suffer most from cuts to government spending. 

Investors would have the security of knowing governments would not be able to print money to short-change bond holders

Mark Kamstra, Economics professor

Investors have much to gain too, say advocates of Trills. At the most basic level, investors might benefit from a lower threat of full-blown financial crisis and debt default, which often leads to costly litigation and large losses. Trills could also be an attractive investment opportunity for several reasons.

“Trills will give investors the opportunity to participate directly in the economic growth of an entire nation,” says Mark Kamstra, economics professor at York University in Canada and a leading supporter of these securities. “This would make them more exciting than old-fashioned government bonds.” 

Mutual attraction

In fact, Trills would have several attractions for savers and speculators. The bonds would be tied to nominal GDP, so they would offer insurance against inflation. “Investors would have the security of knowing that governments would not be able to simply print money to short-change bond holders, since nominal GDP would rise with inflation,” Kamstra explains.

Investors can also get some element of this insurance by buying Treasury Inflation Protected Securities – a US government bond where payments rise with the price level. “Trills, however, would offer much better growth since returns would rise as the economy expands,” says Kamstra.

A study by Kamstra and Shiller also suggests that Trills would be less volatile than equities – another boon for investors.

Pension funds are particularly likely to be enticed by this combination of long-term growth, inflation protection and modest volatility. Trills would be ideal for retirement savings. Pensioners want a fund that keeps pace not just with the rising cost of living but also with the national standard of living. This can partly be achieved through equities but Trills would be more secure. The chance of default would be vanishingly small on GDP-linked bonds issued by nations such as the US and Germany. 

Another advantage for pension fund investors is that Trills would be an obvious security that could be held long term. Pension funds constantly churn their equity portfolios, eating up investment returns through trading commissions and capital gains taxes.

There would be less incentive to do this with Trills, which could be left almost untouched for decades, leading to much lower management costs. In addition pension funds would be able to diversify their investments across the globe much more easily and safely than through equity investments. 

There are potential drawbacks to Trills. Sceptics worry that governments would be tempted to gerrymander GDP figures to slow down the apparent rate of growth and thus cheat investors out of higher interest payments.

There is also the question of statistical revisions. GDP figures are frequently revised – the US’s first quarter GDP for 2009 was first reported at $14.097trn, then revised up to $14.178trn three months later. A year on it was scaled back to $14.05trn and another year later to just $13.894trn.

In other words, the GDP figure for this quarter was revised down by 2% of GDP. This would make calculating the return to investors complicated, opponents of Trills say. “Trills have a strong theoretical appeal,” says Peter Spencer, chief economic adviser to Ernst & Young’s ITEM Club.  “But there are lots of practical difficulties.” 

Supporters believe these fears are overstated. Under-reporting growth is particularly unlikely, says Professor Griffith-Jones.

“It is indeed high GDP growth, rather than low growth, which is considered a success politically and which helps in a major way in getting governments re-elected. Higher growth also encourages higher investment by both domestic and foreign investors, again a desirable political outcome,” she says.

Cost of faking it

In addition, faking lower growth would also make it more expensive to issue new debt. And there are potential solutions to data revisions, Griffith-Jones believes. “The easiest way seems to be to ignore data revisions after a certain date; the coupon payment would be made at a fixed date,” she argues. Either way, Trill advocates believe contracts could be drafted that would clear up potential disputes.

Governments already issue securities linked to inflation and the contractual problems have not been insurmountable. Even most supporters accept that such novel securities might initially suffer from a lack of liquidity. If they were difficult and expensive to trade, there is a danger they would never fully take off. Until Trills had a critical mass they might be undesirable to investors. “Getting them to take off would be very tricky,” says Spencer.

This is partly what makes governments unwilling to issue them. This catch-22 could be overcome through international coordination. Griffith-Jones has suggested governments could issue GDP bonds in coordination. The International Monetary Fund, development banks or the United Nations could help solve this coordination problem.

Some have also suggested that certain companies might attempt to issue such bonds, providing test cases before major governments take the plunge. This might be appropriate for businesses whose revenue is closely tied to the fortunes of a particular economy, especially consumer goods firms. 

The debates have heated up in recent years. It remains to be seen whether any major government will take the leap of faith. “Governments might not be terribly cautious in how much they borrow but they are very timid in how they borrow,” says Chandler.

A bold experiment in GDP bonds would not be without risks. Botched debt auctions are always embarrassing for governments. Officials are also extremely keen to get the lowest possible interest rate. Particularly in the early stages, Trills might impose a slightly higher cost of capital than the tried-and-tested bonds.

Nevertheless, this is an innovation that could pay off handsomely over the coming decades. If GDP bonds work as their advocates envisage, they could help reduce global financial instability and the frequency of disastrous defaults. Citizens worldwide would benefit from more stable government finances with less need for draconian spending cuts and harsh tax rises when the economy is at its weakest. Pension funds may be more able to offer savings plans that keep pace with ever-rising living standards.

It would be a shame if governments were too timid to give this intriguing idea a chance. 


GDP BONDS: At a glance

Sovereign bonds have long been used by governments to raise cash. But there are many drawbacks.

A growing body of thought favours linking bonds to GDP, which would give nations more flexibility and attract investors.

But sceptics worry that governments could gerrymander GDP figures, so cheating investors out of higher interest.