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GDP-linked bonds: Is now the time?

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What if, amid these turbulent times for bond and stock markets, investors could make their bets not on individual companies or projects or even on currencies or market indexes but instead on the overall economic performance of entire countries and with little reason to worry about defaults?

It isn’t an option yet, but Nobel Laureate Robert Shiller, Sterling Professor of Economics at Yale University and the co-creator of the widely watched Case-Shiller Home Price Index, says that so-called gross domestic product-linked bonds aren’t far off and, in his view, could be headed to market in as soon as a year.

“The G-20 organization supports the idea, and while I don’t have any inside knowledge, I know a lot of people in the UK are looking into it,” he says.

Shiller expresses confidence that GDP-linked bonds are an idea whose time has come, and in fact he has a new e-book about them, Sovereign-Linked Bonds: Rationale and Design. The book, which he co-wrote with Jonathan Ostry, James Benford, and Mark Joy, explains how these bonds would work and why they will likely hit the market soon.

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“The market is going to be there,” he says, explaining that GDP-linked bonds will offer both investors and issuers a number of real advantages.

One advantage is that these bonds would pay a variable interest rate based upon the performance of a country’s total economy,

GDP-linked bonds would both permit investors to capture the growth of an economy in a portfolio and allow the issuing country to avoid any pressure to default during hard times, Shiller says.

This is because the interest paid on outstanding bonds would fall when a country’s GDP does, thus taking most or all the heat off the issuer to make required payments to investors and also vastly reducing investor fear about losing principal.

The concept was attempted several decades ago, using warrants instead of bonds, but Shiller says that effort was hurt by the fact that it was over-borrowed countries such as Argentina that tried it.

This time, it would likely be major economies, such as the United Kingdom and perhaps even the United States, he says.

Later, if the idea caught on, GDP-linked bonds, issued by developed and emerging-markets countries alike, could make owning a global portfolio of economies a snap, Shiller says.

Jeffrey Smith, co-principal of Bright Futures Wealth Management, an independent financial advisory firm based in Rockville, Maryland, likes the idea of GDP-linked bonds but cautions, “The most complicated thing will be pricing a new product. My advice would be not to jump in as one of the first to invest in them when they come onto the market. I don’t think it will take the market too long to price them, but I’d wait at least a few months before recommending them to clients.”

This story is part of a 30-30 series on evaluating fixed-income opportunities when rates are rising.

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