Section One: Abstract
In the ever-changing landscape of world finance, indexing debt remains an open discussion. Despite a global consensus that debtors massively benefit from inflationary periods, while lenders greatly lose out, no loans with account for inflation have been brought out. In this article, we will explore the advantages and detriments of indexed debt, as well as any alternative measures that could be brought out.
Section Two: Reasons for Indexed Debt
To begin with, borrowers largely exploit inflation, which effectively decreases the real value of the money that they owe. Having borrowed let's say, a million dollars, and spent it, the inflation in the economy will decrease the money that the person or business owes, while the asset will increase in value at the same rate as the inflation. For example, a house bought with a million dollars will rise in value in line with the Consumer Price Index, while the borrowed cash will do the opposite and devalue, so the home buyer will be better off in the end. This is one of the greatest arguments for the indexing of debt, as lenders lose out on large amounts of money due to factors out of their control.
Another reason for the indexing is the creditworthiness of borrowers. Often, debtors see their credit ratings drop as they cannot pay back their loans during unforeseen inflation spikes. A CPI-based loan will enable them to maintain a steady burden, which will decrease the likelihood of a default, which will also benefit the lenders, who will get their cash back, as there will be a lesser amount of defaults.
Section Three: Why not?
The prime argument against introducing indexed debt is the complexity of the process. Keeping up with changes to the CPI will prove to be a challenge for someone with very little education on the topic, as well as present uncertainty. The general public likes to be able to predict what will happen to their debt. Even if the real value remains exactly the same, their focus will remain on the number, which will increase, leading to a large degree of unpredictability.
In addition to the above, the indexation of debt allows for better opportunities in risk diversification for lenders. Lending out a certain amount of money carries risk, as devaluation
would mean a loss for the lender, so having it indexed would lead to higher certainty for investors at a lower risk, as in real terms, the loan will be payed back in full.
Section Four: Indexed Bonds in the US
Schemes like indexed loans have been introduced before. In the United States, Treasury Inflation-Protected Securities (TIPS) were introduced in 1997 and had seen a variety of benefits, as well as failures.
The primary benefit of TIPS was the protection from inflation, due to the index placed on them, however, another large benefit was the ability for investors to diversify their portfolios with a very low-risk asset, in addition to them being backed by the US government.
On the other hand, TIPS provided a set of challenges. Such bonds provided a lower yield, compared to securities of a similar maturity period, making them less attractive to investors in search of high nominal returns. Furthermore, TIPS are far more illiquid than similar US Treasury bonds. This results in more bid-ask spreads and much higher transaction costs for TIPS holders.
Image from: BBVA
Section Five: Evaluations and Conclusions
As seen in the graph above, at low inflation rates, conventional bonds provide a slightly higher real profit when compared with inflation-linked bonds, whilst inflation-linked bonds provide a higher profit during higher inflation. Therefore, for an investor, it is beneficial to diversify their portfolio with both types of bonds to minimize risks at different levels of inflation.
When it comes to indexing debt, it will be very complicated to organize in the short term. Although it brings out numerous benefits, such as stability for loaners and debtors and lessening the defaults, there are still challenges that are important to overcome. In conclusion, indexed debt will have to wait until it is possible to implement it without any confusion for normal borrowers.
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