GDP-Linked Bonds’ Grueling Growth Pains

With GDP warrants prominent features of the latest Greece and Ukraine commercial debt restructurings, although yet to pay off as with Argentina’s pre-recession, and the international community still in search of new crisis risk-sharing mechanisms, development of standard growth-indexed bonds is again an agenda item for the IMF and central banks like the Bank of England. They have hosted conferences and plan to refine policy, practical and legal guidelines for trial issues where growth swings in both directions would affect returns.  Investors have been wary of the downside and often presume a pricing premium despite offsetting portfolio diversification benefits, while governments tend to be more favorable due to the automatic fiscal stabilization. Early experience with “value recovery rights” during the Brady swap era could have presaged such instruments but application was poorly understood and led to periodic payment clashes especially with underlying global commodity market changes as that asset class likewise evolved. A current impetus is high developing economy debt levels averaging 50 percent of GDP, a three-decade peak, according to the IMF as the equity-like functioning would promote deleveraging. Draft term sheets put the structure in local currency and nominal GDP terms and annual or semi-annual installments. Tax and regulatory treatment can encourage transactions, as with the CoCo contingent debt for global banks spurred by Basel Committee capital standards. They would be senior protected by a pari passu clause and could fall under English, New York or local laws with collective action clauses for majority restructuring under a model template. Statistical integrity is a chief consideration in light of Argentina’s manipulation experience and refusal to follow IMF methodology. A Fund “fall back” could be triggered on challenge to national authorities, and if availability and credibility are totally lacking, early redemption may be an option.

The embedded debt relief could avoid the “too little, too late” scenario the Fund’s Policy Review Department cited in recommending fresh resolution approaches, and private sector fund managers argue that with this imperative initial GDP-linked issues could be partially subsidized to lower pricing and hesitation. As they gain acceptance the sustainability formula must be adapted for program analysis and technical assistance should concentrate on poorer economies with limited debt management capacity. Index eligibility, credit ratings and tradability are other factors. The warrant market was aided by the ability to strip it from the broad instrument and dealers willing to act as separate counterparties, but current market-making scope is constrained by prudential and legal provisions such as Dodd-Frank in the US. The political cycle works against issuer interest as value will likely not be realized until several governments complete terms, and foreign investor opening may not be a desired outcome even if it reduces costs. With higher eventual worldwide rates priority will revert to safe allocation that could constrain GDP-linked novelty, observers caution. If the niche is to expand official Paris Club and EU holders may have to exchange old exposure, and this alternative may be in the mix for future debt forgiveness in Greece to be studied with Germany’s last minute acquiescence linked to release of an overdue EUR 7.5 billion emergency infusion.