The idea is to create long term securities that would be indexed on the economic growth of a country, or rather an economic zone (Euroland...).

Those securities would have two main purposes:

1) To give those countries (or other issuers)

another source of financing,

and a new financial management tool

2) To give investors an hybrid asset

which has some equity's features (variable return and / or capital, based on economic performances)

while basically being a bond(it is a debt).

The index would be the Gross Domestic Product (GDP). This, of course, restricts the potential to geographic zones that respect international economic statistical standards.

The indexation applies to the coupons and/or to the capital refund value.

This might create a negative rate problem if the GDP falls. See below "potential issuers" for possible specific protective covenants for subscribers.

Two possible types  : zero coupon, or with quarterly (or yearly) interest payments.

 (total) Duration : maximum 10 years, as the country's (or zone) perimeter may change in the meantime.

 Nominal rate = the country's or zone's annual GDP variation rate (inflation included). Normally it will be above the rate of fixed rate bonds.

 The price would be determined by an auction (when the bond is issued) and by market quotation (once listed).

Normally the market price will be higher than the nominal value on which the nominal rate applies.

 Basic rate (on the initial auction price or on the market quotations).

Normally it will be below the nominal rate, and below the rate of fixed rate bonds.

 Real rate: calculated by comparison with inflation indexed bonds.

Sovereign states (and regional international organizations) :

The advantage for them is that if the GDP falls, making tax revenues tumble, the lower coupon / capital to service and repay the bonds would partly compensate this.

This could even help revive the economy, by easing the public budget constraints.

However, to avoid a loss of confidence by subscribers in case such a GDP fall occur, some protective convenant might be included (floor, ratchet, conversion option...).

Banks: to grant indexed loans of the same duration for borrowers (small firms, home buyers...) whose income can also rise or fall in sync. with the GDP

Big firms: same advantage, but as a direct issuer.

Other financial institutions: to meet investor's demand

Individual savers for their savings plan, directly or through investment funds (see below)

Investment funds / pension funds and life insurance companies

Foreign investors,

Foreign suppliers, which business depends on the zone's prosperity

Foreign central banks

Hedging products (on future or option markets) may be created using these securities as underlying assets.

Note: As some gdp-based warrants (economic derivatives) are already issued in a small scale by a few big banks, the reverse, which is to create synthetic gdp-indexed bonds, is already possible.

Assets splitting (and recombining) would be possible. That would consist in separate market quotations of each annual tranche of interest, and of the capital refund value (in fine, or in several tranches).

Cyclical firms (for GDP insurance in the geographical areas where they have a high stake)

Individuals (same hedging objective for their asset portfolio or their future income)

Financial institutions and professionals (hedging stocks against the real economy, to compensate for possible lags, leads or divergences in their respective evolution)

Other traders

But a problem arises:  is there a real "GDP risk mutualization" as this risk is systemic and that it hits all the players in the same way?
That would work if there are enough speculators acting as counterparts. Moreover, there would be mutualization between the big economic zones of the world if each one issue this kind of security.

We have seen above that, for sovereign states, those bonds would bring advantages in budget management, but also would help to self-stabilize the business cycle of their country

 

Also those bonds might facilitate economic previsions.

Economists always have a problem to forecast the economy's future growth. Maybe the market for those securities would help them (hey, I didn't say can replace them ;-). In principle (but herd instinct or "rational" anticipation might distort this), their market value evolution would be an indicator of the general opinion on the economic prospects for a given area,

in the next 10 years,

and, if the securities are split into annual components, in a shorter term or even year by year.

This estimate of the economic prospects by the market would easily be computed by comparing the market evolutions of the prices and returns of those GDP-bonds to those of:

Fixed coupon bonds

Bonds which are indexed on current market LT or ST interest rate,

Bonds with their interests / refunds indexed on inflation

Bonds indexed on other countries' GDP with the same currency (or with another currency, by taking into account the evolution of the exchange rates and interest rates swaps quotations)

Not forgetting the stock market indexes : compared to stocks, the market price level of a GDP-bond, and its evolution (divergence or convergence) would be an indicator of:

* Distortions in wealth anticipations or in income repartition between stockholders and other stakeholders (other savers / investors, borrowers, employees and pensioners, consumers, residents and non-residents...),

* that would allow to better spot the respective rates (thus the respective risk premiums) of these two assets.

Here are some risk factors:

Like for any security, its value depends on the solvency of the issuer and on the liquidity of this asset's market.

The price evolution of other assets (stocks, fixed rate bonds, inflation-indexed bonds, commodities), can influence buying and selling, thus have an impact on market prices.

Changing trends in macroeconomics would influence prices (well, it is one of the purpose of those securities to reflect this).

Psychological elements affecting investor expectations (over-optimism, or over-pessimism, about the country prospects) might distort the prices and valuations of this security as it is the case for other financial assets.

There are also specific risks linked to the reliability of GDP statistics.

The GDP is supposed to measure how many riches a country produces in one year, what is called its "value added". Like about all indicators, it is not perfect.

Some productions are left out (the grey economy for example, but also all what it is produced for self-consumption).

Others are just shifts of activities (things that were free or self-done can become market products).

The "non commercial" production of the state, municipalities, charity organizations... is counted at its costs (salaries of their employees...)

Asset depreciations are not deducted (whence the term "gross"), nor some losses of assets (catastrophes), nor positive or negative "externalities" (side effects, collateral windfalls or damages).

Also the figures might be tempered with, before or after inflation) for political reasons.

Anyway, whatever the criticisms, this indicator is usually considered the best, or at least the less bad, measurement in town of a country's economic activity.

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