The basic concept of GDP-linked government bonds is for their coupons and principal payments to be indexed to nominal GDP and in so doing allow both the burden of servicing interest payments and repayment of principle to adjust with the sovereign’s ability to pay.
The major market and social welfare benefit of this is to reduce the risk of sovereign debt crises and disruptive defaults during a recession or downturn. In this regard, often GDP-linked bonds are seen as a form of holding equity in a sovereign, whose entire return will vary with economic performance instead of on a fixed basis.
GDP-linked bonds can be designed to reduce the default risk premium by allowing the debt servicing burden to be reduced in times of fiscal duress. On the other hand, for investors, particularly those who believe a particular sovereign may be on its return to prosperity, GDP-linked bonds offer returns that can later outperform corresponding conventional bonds.
Over a longer period of time of continued issuance, GDP-linked debt as well as other forms of state-contingent debt could work to de-risk sovereign balance sheets.
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