This page has had an introduction added to show the bigger picture. It is a new script and may be edited during the next few days to improve clarity and spelling.
The part relating to government issued Wealth Bonds forms the last section. It is a long page - the subject takes a long time to get your head around because you are learning how to apply the principles of Macro-economic Design as laid down by this research group. Basically to prevent massive imbalances from occurring in the world's economies the pricing mechanism has to be permitted freedom to adjust. There is no other obvious reason why imbalances should arise in a serious way. Some prices such as interest rates and currency pricing try to perform in ore than one field of activity which gives rise to mind bending problems for those who seek to address the problems with interventions. This section deals only with the pricing of savings and debt. Ingram Lending and Savings (ILS) models are discussed.
There is more than one campaign group advocating that the world adopts Wealth Bonds and ILS lending models of various kinds. Wealth Bonds are one of those kinds. The first step is to convince the science based financial community that it is all clear and complete. As a few people have already said it is academically sound - see PEER REVIEWS for example, all the way down, the page. The General Equations for Lending make a fairly good job of that, as testified in the peer reviews.
The most important thing about Wealth Bonds and all of the ILS Mortgage models, is that for an economy to be able to recover its balance it must first get these things in place. These are the self-balancing foundations upon which all economies must be built. The basics are to allow prices, costs, and values, in the savings and lending market, the freedom to adjust so as to balance supply with demand. That is basic text book economics.
But instead, we have all kinds of contracts and regulations which prevent this from happening. This results in the major part of the problems being faced by the developed world's economies as explained both on the Home page and on the LOW INFLATION TRAP page. But it also significantly retards the ability of the developing economies from deploying large amounts of capital which is needed for housing, for infrastructure, and major business projects. On the savings side it results in too low interest rates. On the boom and bust side it enlarges the natural undulations in the cost of housing significantly if lenders and regulators ignore the mathematics of risk management as laid down in the General Equations for Lending. When done properly, the amount of wealth which it is safe to lend or to borrow does not vary a lot over time even as nominal interest rates and inflation rates rise and fall significantly. So similar amounts can be borrowed in both high and low inflation environments. You just have to deploy the right kind of savings and repayments contracts. Everything will adjust and within reason, the changing rate of inflation can be managed. Spending patterns will not change much because of the way these contracts are designed and regulated, but the level of demand in the economy as a whole will be free to vary so as to match aggregate spending with aggregate economic output. A selected rate of inflation of demand can be targeted allowing an loosely estimated rate of prices inflation to be targeted. It is better to target demand than prices. Then it is up to the central banks to set the rate of inflation that they want.
On the savings side, there are variable rates of interest and there are semi-variable rates based upon Wealth Bonds, also known as 'Floating Rate Notes' in which the floating rate part of the interest results in the indexation of capital at a rate which preserves the wealth that has been lent. This is the proposed link to National Average Earnings, NAE. The fixed rate part is the marginal rate above the NAE index or in the case of an index-linked bond, that is the coupon interest rate. This coupon part of the interest is called the true rate of interest. With the interest rate model the true interest is the marginal rate above AEG% p.a.
Once that has been done the key concern of lenders, that of a shortage of new funds to lend in the case of deposit taking institutions, is already addressed: nominal interest rates can be raised without causing a massive amount of arrears or property price falls. Instead of asking borrowers to pay varying monthly amounts as nominal rates of interest vary, they are asked to repay the wealth (the NAE) borrowed at affordable rates. These start high at around 30% of income for a single borrower and fall every year towards 11% at the end of the repayment period, say 25 years. Repossessions will not cascade out of control. As the text books say, if the price (the interest rate) is right, the books will balance. As true interest rate prices rise, fewer people will want to borrow and more savers will be attracted to deposit their funds. If there is some stickiness in the market response on the deposits side when interest rates rise, the central banks are there to help out over the short term by supplying the necessary liquidity. But it is likely that lenders will not run into that problem because money markets can be very liquid. In particular, if lenders tap into the long term Wealth Bond market by offering fixed true rates of return just a fraction higher than investors can get risk free elsewhere, or net of risk elsewhere, there ought to be almost unlimited funds available. The problem then will be finding enough borrowers going forward over the same time period. This can be addressed in the usual way by having early termination penalties for borrowers, and limited term fixed true interest rates. Another solution is just to wait for the level of repayments and early terminations to provide the cash inflow needed. Together these usually run at over 20% of deployed loans (the loan book) p.a. A typical loan lasts on average for up to 7 years only, and there are repayments coming in as well, plus the profit margin on interest.
What we have right now is savings and loans contracts which destroy the natural self-balancing nature of an economy - that is an economy in which prices, costs, and values in the savings and lending sector are not free to adjust as necessary or without impediment. In fact they either cannot adjust at all, as in the case of fixed interest contracts, or they overwhelm the natural pace of cost adjustment as in the level of monthly repayments on housing finance, for example. What this link to nominal interest rates does is to automatically create imbalances in the economy in sectors that are major parts of the dynamics of the economy. It creates uncertainty because it unbalances the books of businesses and governments and home buyers and lenders' cash flows too; and it distorts the natural spending patterns that we should have when people are spending their money to obtain the things that they most want to spend on within their means. When the cost of housing finance does not adjust alongside most other things - changing fast instead of slowly like everything else does - this prevents a large part of the population from spending on what they normally spend on and it affects property values as well. Interfering with spending patterns destroys jobs very fast and this simply creates a downwards spiral in the entire housing sector and the whole economy.
When the money value of fixed interest bonds is unable to alter (adjust), it makes it impossible to put a value on them and a lot of costs and problems arise out of that. This creates a significant risk premium that costs a lot of money for borrowers and does not remove all of the risk for savers.
What is the real problem? It is the way in which the lending and savings contracts are written, (designed), and enforced. Prices (interest rates), costs (monthly repayment costs), and values (bond values and property values), are far from reliable. They do not adjust to the changing level of demand in the economy, the rate of change of NAE and spending. In order to market fixed interest bonds, the institutions cannot offer savings and pension contracts that guarantee anything except money back plus some interest of uncertain value. Used as reserves, fixed interest bonds do a bad job because the value of reserves in money terms needs to be index-linked to NAE or some similar index that represents the changing level of demand and business turnover linked to rising demand and rising earnings per person. On the savings deposit side, taxation takes away the value of interest received to the extent that it taxes the indexation rate, the amount of interest needed to keep pace with NAE.
The ILS range of savings and lending models are designed to permit the cost of loan servicing to adjust and to broadly keep pace with changes in the rate of change of NAE, the rate of Average Earnings Growth (AEG% p.a.), in the economy. It also adapts the repayments profile to be gentle on borrowers to ensure that arrears levels are under control. For new borrowers, they always start with high payments and end with low payments. That is to keep pace with the changing level of spending per person which impacts on the prices of just about everything in an economy including house prices. Spending levels are not exactly the same as income levels but they do have to follow one another over time for else there would be an ever rising or perpetually falling level of savings from unspent or over-spent earnings.
In theory, interest rates are also linked to this AEG% p.a. rate of change. See other pages on this website and read about Grandpa' fund. So both costs and prices (the rate of interest) can be free to adjust properly if we get rid of arrears issues on the loan repayment cost side and allow lending interest rates to adjust.
If lenders cease over-lending (high risk) and under-lending (low risk) as the nominal rate of interest changes, then 'loan: income' ratios will stabilise and property values will adjust nicely to the changing level of NAE. If people use Wealth Bonds instead of fixed interest bonds those values will keep up with everything else.
Overall, cash flows, (costs), and values, along with interest rates (prices), will be better able to adjust so as to bring about a better balance between supply and demand in the entire savings and loans and property sectors - and the overall economy. A lot of volatility and uncertainty and risk premium costs will be eliminated.
For more information on the kind of financial products that come out of this, please read the page entitled FINANCIAL PRODUCTS RESULTING or follow down this page which covers much the same ground.
For information on how to transition from the state that our economies are in now to the new state there are some guidelines given on the LOW INFLATION TRAP page.
For information on interest rate behaviour please read the page entitled 'Finding the mid-cycle rate of interest' and the page on Siegel's Constant.
The remainder of this page gives some helpful test results and illustrations. And it begins by explaining why bonds linked to GDP may not be such a good idea.
This page / concept of mine existed long before Robert Shiller thought to suggest his Trills - Trillionths of GDP linked Bonds. In fact the idea goes back to 1974 when I was publishing my series in the Building Societies Gazette. But I probably did not publish the idea expressly at that time - people can only digest so much. The first reference made to true interest rates appeared in my letter to The Times on 11th April 1975 but without any explanation given. What Professor Shiller appears to have overlooked , besides the latest information on the definition of wealth in this context (preservation of NAE - see the Home page), is who the customers are going to be and what are their needs when it comes to selling his Trills. Wealth Bonds fill both gaps: they preserve wealth and so they have huge customer appeal. That is why they are not called semi-variable interest rate bonds or floating rate bonds - where is the customer appeal in that? Besides, floating rate bonds have established themselves as being linked to prices or to (distorted) interest rates, or not wealth - right? Wealth Bonds can also provide a part of a level playing field for all forms of investment, enabling institutions to determine more accurately which investments provide the best 'risk: return' ratio. This is because, as explained, in the long run all already, prices, costs, and values including investment values are moved when there is a change in the level of NAE, and by a proportional amount, compared to the prices, costs, and values which would otherwise prevail.
ESCAPE FROM LOW INTEREST RATES
Wealth Bonds can help to create a significantly stronger and better performing economy, because they take out much of the instability and risk, cutting down the risk premium, and they can allow central banks to raise interest rates without worrying about the consequences for lenders, savings, and borrowers. For investors, the security is unmatched because the repayments are made affordable provided that there is an income stream that is reasonable for the borrower. And the investment return can, in a thriving economy, be significant - at least enough to prevent interest rates from falling too low for too long and all of the abuse of economic resources which comes from that.
There is also a use in facilitating economic recovery as central banks permit interest rates to rise. This will take a little engineering to ensure that in the change-over to wealth bonds and the new variable and semi-variable interest rate ILS Mortgages discussed in these pages, does not damage vital sectors of the economy. But that can be done. Otherwise...
...Potentially huge losses may be incurred by investors in fixed interest bonds if our economies recover from a recession or if QE raises inflation rates above 2% with incomes rising at above 4% p.a. as normally can happen in normal conditions - See Table 4 below.
Definition - An ILS Mortgage is one of a range of Ingram Lending and Savings Mortgages - as described on these web pages. In one version called 'rent-to-buy' the early payments during the 'rental' period create the deposit. The later payments are the 'buy' period. Default during the 'rental period' leaves the property and the early payments in the hands of the lender. The mathematics behind ILS mortgages and wealth bonds can be found here.
WHAT ARE WEALTH BONDS?
There are several formats for wealth bonds, depending on their use - government debt, business debt, or Mortgages. All have either an interest rate, or an indexation rate, which is tied to National Average Earnings (NAE) which will be rising at the rate of average incomes / earnings growth (AEG% p.a.). Plus interest on top. If interest is used it is a semi-variable rate. If you are interested in the Greek situation scroll down to read about Sovereign Debt using Wealth Bonds.
What are Trills? These are a suggestion from Robert Shiller - they are bonds issued by governments in which the capital is index-linked to GDP. Each Trill (bond) has a value of one trillionth of a GDP.
These also fall into the general category of Wealth Bonds as defined and discussed in my draft book and various linked blog pages over time. They fall into this category because they have a link to Average Earnings Growth, AEG, through the definition of GDP, which is sometimes defined as the total national income from all sources. But the two measures can diverge, especially over time, and at times when immigration / emigration affects GDP for example. If 25% more people had work in Greece that would have a huge impact on the value of Trills. It would not have the same impact on the value of Wealth Bonds which has a more social appeal, making everyone somewhat more equal - everyone's wealth (savings) becomes linked to the average earnings of the people.
There is another reason for using National Average Earnings (NAE) as the link. Here is an extract from a previous script that appeared on the Home Page:
ALL IN HARMONY
Without going into too much detail at this stage, as NAE rises, so all prices should tend to rise including investments, company turnover, costs, profits, dividends, share prices, rentals etc. To keep a sustainable balance (something which has never been achieved but which nations strive to achieve by manipulation of interest rates), interest should add to savings and loans at a rate which keeps that balance. They should add 1% to the money value of accounts for every 1% rise in NAE. It is not possible to make National Average Earnings (NAE) rise at a constant Average Earnings Growth, (AEG% p.a.), rate. Therefore, in a sustainable and well balanced economy, the AEG% p.a. rate should be a guide as to how interest rates should change; and, given freedom to do so, that will happen. If all prices, costs, and values can be free to adjust, spending patterns will not change. Employment patterns will remain the same.
NOTE: When Edward first started studying average incomes, looking for an index in the UK there was only one index for average earnings. Hence the terminology that he grew up with was Average Earnings Growth (AEG).
For the purposes of his mathematical studies of mortgage and other finance, Edward defined wealth as saved income and protection of wealth as keeping pace with an index of national average incomes / earnings, NAE. The reason for doing this is that if an investment does not keep pace with AEG% p.a. (the rate of growth of NAE), then another entity will get a part of the saved income / wealth that has been lent or used by that other entity.
This extract from the prior Home page explains that somewhat:
Edward Ingram likes to give this example: Imagine this: a fund valued at 20 National Average Earnings, 20 NAE, (around half a life-time’s earnings for an average person), was invested by your grandpa to keep pace with a prices index. A century later, when you were expecting to inherit this fortune, and to be able to spend half a lifetime spending it all, you are told that it might be worth just one year’s National Average Earnings, 1 NAE. That is a 95% loss of NAE over the century. You are shocked. It will be worth, not a half life-time’s earnings as intended, (the original 20 NAE), but closer to 1 NAE – just a single year’s average earnings. Other people got the main benefit, not you.
That is because it is usual for earnings to rise faster than prices. Here, the difference in the rate of increase between rising earnings and rising prices was assumed to have averaged 3% p.a. for 100 years. That is, about 3% p.a. real economic growth, which broadly, is accepted to mean the difference between the rate of average earnings growth (AEG% p.a.), and the rate of prices growth, (inflation). As earnings rise faster than prices we all, savers included, should become better off.
This is also easy to demonstrate with a spreadsheet and it has been illustrated on a number of pages, including in chapter 4 of the draft book.
MORTGAGE BASED BONDS
A wealth bond can be used to fund a secured loan with a predefined, and reasonably affordable repayments schedule, one that gets less costly against an index of average incomes / earnings, every year. This is what normally happens with a fixed interest rate mortgage when average incomes are rising all the time.
Whereas normally the borrower does not know what the cost-to-income (or the cost to average income) will be because incomes growth rates cannot be forecast, with a Defined Cost ILS Mortgage, that question is resolved. Given a predefined rate at which payments get easier relative to the AEG index and a predefined total repayment period, the borrower knows in advance how much wealth (NAE) the mortgage will cost. And he/she knows that even if income does not rise every year as fast as average, the payments will be affordable. The lender knows that the level of repossessions will be correspondingly low and that the mortgage will be secured by the property.
These sketches show what that may be like and how fixed interest bonds can be catastrophic in these terms as people in Europe should very well know.
Figure 1 - A wealth bond driven ILS Mortgage
The '% of income' needed to repay, based upon an index of NAE falls every year at say, 4% p.a. repaying 3.5 times income in 25 years if the marginal rate of interest (the coupon, also known as the true rate) is set at 3% p.a. above AEG% p.a.
The 21% line is there as an illustration of how a typical rental might keep pace with AEG% p.a. under market forces. The cross-over cost occurs about mid-way through the repayment period.
Figure 2 - A Fixed Interest Mortgage or Sovereign Debt, when incomes are falling, or for governments whose revenues are falling is dangerous:
Potentially it can look like this.
The picture for the Defined Cost ILS mortgage is still the same as in Figure 1 above. Money is rising in value (spending is in short supply). Everything, including the value owed and the cost of the repayments, adjusts.
For the investor in wealth bonds, the rate of return is linked to AEG% p.a. plus a true interest rate margin that is fixed. This fixed margin is the gross rate of return in units of NAE which the lender is earning from the borrower before costs, or if you prefer, it is the rate at which income (NAE) is added to the value of the loan before any repayment is made.
For a Trill or a GDP-linked Wealth Bond, the rate of return might be measured in units of GDP being added to the debt or paid out as interest.
The borrower has to pay a bit of interest so as to cover all of the costs of administration including legal fees and insurances and so forth. That is, assuming that the market forces are there to ensure this. Normally they would be there. Not currently. Currently Wealth Bonds may have to be sold at a premium so as to come into line with the extraordinarily low and distorted market rates of interest. Readers who think that such conditions mat recur should cast away that thought after reading the complete list of reforms being proposed on these various web pages and related essays at www.fin24.com. (Search for edward ingram). Hopefully the entire book will be available soon.
The coupon, the yield above the index, is usually referred to as the true rate of interest.
MORTGAGE BORROWER VIEWPOINT
Wealth Bonds linked to ILS Defined Cost Mortgages protect both parties, if not from currently vulnerable property values, then at least from repossessions and loss of wealth. Normally, if and when inflation takes off, property prices may be vulnerable but after a while property prices would rise with inflation of course. But most people do not want to move house on account of property values changing. They just want their payments to be affordable.
A video presentation of this kind of mortgage can be found on U Tube here.
Normally a marginal rate of interest above AEG% p.a. will be added. But if the rate of interest was equal to AEG% then the income lent, say four years' average income, will be the total amount of income that gets repaid after adding interest. Just add up the '% of income' paid every year to get the total. See the 'Average % of Income' Column in Fig 1.
Fig 3 is an amazing example of the maths in which it is possible to have the interest rate rising every year yet the payments are falling relative to the index and the interest is set to be equal to AEG%. There is no additional marginal, or true interest, to pay in this illustration.
Check out the '% of income' column. This is the income used in the payments every year. The payments are pre-set to fall against the NAE index at 4% p.a. every year. It is the pre-defined rate of easement in the contract that applies every year. The contract does not know what will happen to other interest rates nor to AEG% p.a. but it says that the core rate of interest (the variable part) will be equal to AEG% p.a. whether that is rising, falling, or standing still.
In this illustration AEG% p.a. rises every year and interest rates rise at the same rate.
The loan was 4.84 years' income, which is abnormally large. By adding up all of the 'income %' used we find that the total repayments add up to 4.84 years' income.
If the same AEG and interest rate scenario happened to a normal Level Repayments (annuity style) loan the payments would look somewhat different as shown in this comparison of the two models:
The LP Mortgage is even more inflated because it is cheaper at outset and more is lent - something that is very dangerous. In these illustrations both models lend more (not recommended), but the ILS model has less risk because the loan is smaller so that the payments can fall every year relative to the index of NAE. The other point about the ILS model is that both sides, the lender and the borrower, get protected by the ongoing affordability of the repayments. But the repayments under the more traditional Level Payments (LP) Model can become unaffordable at an early stage. Despite the total wealth cost being a net zero figure: NAE amount borrowed = total NAE repaid in both examples, the repayment profile of an LP Mortgage is out of control.
If the marginal rate, which as stated earlier, I have named 'True interest' (see the GLOSSARY), is 1% above AEG% then about 10% more wealth will be repaid. But that might be consumed in costs, with less payable to the bond investor who provided the funds..
Here is a more realistic example where the two parties agree on a 2% true rate of interest and conditions are variable:
Now the lender is getting paid 23.7% more income / wealth / NAE back than was lent.
In reality, true interest rates will vary over time but they cannot rise very far above the mean level for long, nor fall below it for long as explained on the two blog pages about Siegel's constant and the LOW INFLATION TRAP.
INVESTOR RETURNS ARE HIGHER
Let us forget costs for a moment and look at what this means for an investor in wealth bonds.
If all repayments and interest is re-invested by the wealth bond investor / lender, then below in Fig 6 is a table of returns from a 25 year fixed true rate Wealth Bond. This is a simple compound interest table for NAE with interest compounded up. The first and last columns show the investor's data and the middle columns show the borrower's data. The net total cost to the borrower is the excess income (NAE) repaid compared to the income (NAE) originally borrowed, including all interest payments.
Note that the nominal interest rate r% is not shown. The table assumes that AEG% p.a. = 4% so a 1% true rate of interest is a nominal rate of 5%. The Entry cost is the cost of the initial repayments.
Fig 6 - True rate investor returns (Final column) and borrower costs (third column) over 25 years. Borrowers frequently do not complete the full term, but for an investor, the lender may re-lend the money (as assumed herein) keeping the investor fully invested throughout.
Source: Edward C D Ingram spreadsheets
## Now we see that although the borrower repays 22% more at 2% true interest. If the bond holder re-invests those repayments, by the end of 25 years he/she gets 64% more wealth / NAE, than the income (wealth / NAE) lent, less costs. The lender has to pay the costs and collect them from the borrower. So the borrower will be quoted one true interest rate and the investor will offer another. The difference is the lenders' costs and profits.
What borrowers using other mortgage models, such as fixed interest bonds do not know is:
- How much wealth in terms of the AEG index will be needed to repay the mortgage.
- How fast their payments will ease (the rate of payments depreciation) or whether that rate will be positive or negative, if they are using a fixed interest bond. So they do not know what the cost will be in NAE or as a '% of income' even for an 'average' borrower.
- If borrowers use a variable rate mortgage (no wealth bond directly involved although lenders may be using a mixed fund), then they do not know what their payments level in money terms or any other terms will cost over the period.
The ILS Defined Cost Mortgage answers all of those uncertainties. The figures are guaranteed by the contract.
With a wealth bond the true rate is fixed for the duration of the contract. The only problem is that the term of the bond may be cut short when a borrower moves home or sells up. Then consideration will need to be given to re-investing in a new wealth bond at the new current market rate for wealth bonds invested in mortgages. Lenders and investors will need to have an agreement on what is and what is not guaranteed in that respect.
An ILS Defined Cost Mortgage protects the wealth of both parties to the contract, as well as removing both the interest rate risk to the monthly payments and the inflation risk to the lender. And there is another risk that the borrower escapes from: the risk that incomes will not rise for many years leaving them with very high costs for a long time. If incomes are falling then the borrower is still protected with payments that fall faster.
In such a case drawn to my attention in Ireland, some incomes are falling at 5% p.a. and interest rates can be as high as 4.5% so the true rate is 9.5% for that sector of the community. Imagine having to fund their pensions and you get this 9.5% p.a. true return on your Bond! Well lenders cannot lend at a fixed true rate at that cost, but there is a variable rate option which I have illustrated for the Irishman who asked.
Mortgages in places like Japan where incomes are not rising or in other places where average incomes are falling can still offer a pension fund a good return because money may be rising in value.
COMPARATIVE RETURNS ON WEALTH BONDS
Siegel's constant suggests that an equity investment may provide a true interest rate equivalent of 3% - 4% p.a. over the long term. You can look this up with a Google Search.
But there is some debate over the applicability of the data:
Property values usually offer a lower long term average rate of return than equities. You can check that out too either at the same time or by looking at the Fidelity website www.fidelity.com
The long term true rate of interest on mortgage finance will be above zero because that costs nothing for the borrower and my researches of past data for the UK found that the true rate of interest on prime mortgages was around 3% p.a. But the rate varies from year to year.
The true rate is the difference between the two lines shown for AEG and interest rates. It is shown as a just visible line in yellow.
I gave more information on estimating the mid-cycle rate of true interest on this page:
And the dangers to an economy of getting nominal interest rates down too far on this page:
In the latter discussion on the low inflation trap the wealth bond scenario opens the escape hatch enabling the economy to grow past that scenario of long term low growth. Thus ILS Mortgages and wealth bonds are a part of the new model for our economies that I am proposing.
OTHER FORMATS FOR WEALTH BONDS
Wealth Bonds can also be designed with a variety of repayment structures to suit different business models / projects.
CAPITAL WEALTH BONDS
Some businesses may want to defer all payments in the first year or two but the wealth bond will still protect the wealth of the investor and it may attract a higher rate of true interest if there is greater risk. The lender has to ensure that the bond is well secured. Because the rate of increase in average business turnover has a relationship to average earnings growth (spending levels) the borrower has full protection from inflation of NAE through the indexation of the debt without having to repay that part of the interest. This means that the borrower is better able to determine how much capital needs to be borrowed. Less capital actually and maybe even as little as half the capital needed for conventional fixed rate loans with capital and interest payable from outset. The early cash flows can be managed better. To get an equivalent size and cost of a loan a business needs tax relief on the interest, or an interest free loan with delayed repayments. Yet when the business is in most need of that there are no profits with which to obtain that tax relief.
A QUESTION OF TAXATION
Will these wealth bonds obtain any tax relief? That depends on how they are constructed (index-linked and tax free by negotiation with the revenue people) or all interest and getting too much tax relief when profits are coming in and not enough when profits are not coming in. Tax authorities need to level this playing field by taxing only the true rate of interest for lenders and giving tax relief on the same.
MATURITY WEALTH BONDS
A bond where only the true interest is paid, may also be a suitable way of funding the early years of a new enterprise as long as, in both cases, (Capital Bond or Maturity Bond), the loan is well secured or the company is a blue chip company. The maturity date may be fixed or negotiable when profits roll in.
When profits roll in, then the repayments can get started on an agreed repayments schedule by negotiation between the lender and the borrower. There are a variety of possible constructions for repayments including the Defined Cost Mortgage Model already explained above.
A zero rate of payments easement might work well for a business loan with the cost rising as fast as AEG% p.a. But that is negotiable. A higher start would ease the cost of the payments over time and provide a greater degree of security with more flexibility if the business gets into difficult times going forward.
Business loans of this kind may well attract a true rate of interest that is greater than the return obtainable from equities over the long term which according to the page on Explaining Siegel's Constant is not a high rate of return. Maybe only 4% true. Investors and fund managers may also be wise to brush up on ways to estimate the mid-cycle rate of interest.
Some research papers are needed to explain how this knowledge can be adapted for some of the more volatile developing economies. Let me know if you are interested in doing that.
Central banks can also benefit from a better knowledge of how interest rates are linked to AEG% p.a., the undulations in spending caused by undulations in credit demand and in savings rates and the inter-action with other currencies along with undulations in imports and exports. You will need to know about or learn about control systems management and better management of the business cycle. And about how to use wealth bonds for government borrowing.
LENDERS AND BUSINESSES
It may be wise to offer a lower true rate in the early years so as to safeguard the wealth and the collateral cover, but by agreement at outset, that low initial true rate could be increased once the business became profitable and repayments began.
LENDING MORE THAN IS USUALLY POSSIBLE
In developing nations and nations where interest rates and inflation rates are BOTH high, these wealth bond structures come into their own enabling investors to find a better way to earn money from lending and enabling lenders to lend much more than usual and enabling businesses to borrow much more than usual.
GOVERNMENT / SOVEREIGN DEBT
If governments were to replace all of their fixed interest bonds with wealth bonds it would remove significant amounts of risk to the wealth of investors and risk to their future and even the present cost of borrowing.
The increased wealth protection would also help to reduce volatility in the value of the currency. That is whilst we still use the present currency price management models which are quite interest rate sensitive.
People say that an index-linked bond linked to the prices index will do the same job. It will not do the same job. The prices index tries to protect people from shortages of oil and food and doing that does not increase the supply of those things. It is a dangerous guarantee to give that is unfair to those whose assets are uninvested in such bonds, and it is unfair to tax payers who have to pay for that kind of borrowing at such times.
At other times, for investors, these bonds do not guarantee to protect wealth. the prices index lags behind the AEG index by about the rate of real economic growth so look at Fig 4 above and see how big the investment losses may be when real economic growth clicks in and the true (marginal) rate of interest added to the index-linked bond does not increase or move around sufficiently to cover the gap.
A wealth guarantee will sell. All meaningful guarantees sell - it is a matter of explaining them.
FUND MANAGERS AND PRIVATE INVESTORS
USES OF WEALTH BONDS
It would be wise to read all of the above and then read this summary of how you may be able to protect your hard earned wealth and your pension from risk and from inflation of other people's incomes leaving you with a gap in your wealth.
Wealth Bonds can be included in annuity contracts and in pension funds where the clients wish to see their exposure to equities and property reduced. Wealth bonds are on the same platform (playing field) as equities and property investments because they are all linked to rising income and rising spending in the economy. And they lack the volatility and risk over the short and medium term up to ten years or even decades in some cases. If you want to be certain of protecting your wealth, your NAE, you need to invest in Wealth Bonds.
If you want to have some protection for your mutual fund in case of a market downturn just before you need your money, select a mutual fund that has an appropriate percentage invested in wealth bonds.
The main difficulty is regulations and taxes. You need to know how these may affect your investment in your particular economy. And as for investing in mortgages, and business loans, be aware that in some nations laws to protect the borrower can be very much against your best interests. For example, in America Home buyers can walk away from their mortgages and be protected from further liabilities. And there are Chapter 11 Bankruptcies and just bankruptcies to cope with.
You need to be careful or you need to insure these risks with an insurer that you trust. Today I would not be sure that any insurer can be trusted because the derivatives market is all-pervasive and it is said that one insurer is buying insurance for another and the process is repeated so many times that maybe the first insurer ends up insuring itself or if any part of the chain breaks they will be exposed. To an extent, the degree of caution needed here depends upon in which country or state you are located. Some nations like states in the USA have guarantees for policyholders with insurance companies that go bankrupt, but even so I would query whether those funds are good enough in these days.
To get our Badge of Safety any financial institution, investor or lender will have to reach an agreement and an understanding with us on such issues.
REDUCING VOLATILITY RISK FROM A FUND
Wealth Bonds, especially those that are safe government under-written Wealth Bonds and those lenders who issue them and are covered by our Badge of Safety, can be included in the asset mix of ANY fund where a lower wealth risk level is needed, without compromising the long term safety of the wealth invested in the fund.
REDUCING BETA - MAYBE
It must be pointed out that the investment industry is used to the term 'Beta' which is not wealth related as defined, so a new term may be needed, and a new sales pitch can be opened for the selling of wealth protected funds.
A measure is needed to replace Beta Value in this case with 'Wealth Risk Value'.
FINANCIAL ADVISERS AND FINANCIAL INSTITUTIONS
MARKET RESEARCHES NEEDED
Ask your market research people this: "What does the public really want?" Do they want their wealth protected and enhanced or do they want money guarantees not knowing what money may be worth? And do they really want that much risk to go with pure equities or property funds? Fixed interest bonds can be disastrous, if AEG% p.a. rises with the next economic recovery leaving fixed interest bondholders holding a near-worthless investment, as a look at Fig 4 will show - you can easily get into a negative true interest rate scenario that way. Advertise this information and make friends with your clients that way.
When I take my pension I want it to be at least partly invested in wealth bonds, with the rest invested in property or equities since I am expecting these to rise faster than AEG after the world economic recovery. But at least 60% in wealth bonds would be about right for me I think, having retired many years ago at age 52 to pursue these researches funded by my own savings.
I am fortunate to have a significant retirement fund already. Otherwise I would go for at least 80% in Wealth Bonds.
NOTE: Since writing this I have been forced by reaching age 75 to take my retirement fund into a new arrangement which suits me so badly that it is rotting, waiting for something to change because all investments seem to be over-valued.
KINDS OF WEALTH BONDS TO OFFER TO FUND MANAGERS, LENDERS, AND PRIVATE INVESTORS.
From the government's standpoint, it is a good idea to sell into as many markets s possible. The bigger the market the lower the cost in interest rates. Governments are generally regarded as safe to lend to so with safety of wealth protection on offer from a government you cannot get much closer to a risk free benchmark investment.
But different borrowers need different maturity dates to match their fund's liabilities to deliver maturity values to clients. This is well known and is no different from wealth bond issues.
What fund managers like, because they like to have a high level of cash inflow as a way to re-balance the fund or to cope with a high level of withdrawals, is to have a high cash flow from their wealth bonds. With wealth bonds likely to have a very low coupon such as 1% p.a. they would not seem to appeal very strongly to fund managers.
However, there is no reason not to offer wealth bonds that pay out both capital and interest or wealth and interest to be more exact. Then the government will have to issue new wealth bonds to manage the capital outflow. Normally, with traditional bonds sales take on a 'stop, splutter, go' pattern as no one really knows what they are worth and those assessments can change on a hourly or even a minute by minute basis. With wealth bonds, it is much easier to make that assessment. The only impediment for the buyer / investor is the uncertainty of whether or not there is a better short term investment.
For the purpose of annuities, paying back capital and interest is an ideal way to match the cash flow needs of the market because that is exactly what annuities are supposed to do. Using wealth bonds, actuaries will not be troubled at all in offering wealth protected annuities or annuities that pay more wealth at first and less later or the other way around. The public will go through an amazingly helpful learning curve and will be much better able to determine how much they need to retire on in comfort.
For example, a fund of 10 NAE can provide an income of 1 NAE p.a. for 10 years or 0.5 NAE p.a. for 20 years, less admin costs.
PROBLEMS WITH TOO MUCH BORROWING
The market for debt is always limited, or it should be. If fractional banking continues it is easy to offer too much debt and lead the economy into a boom and bust cycle or rather a credit cycle which is extremely hard to recover from as everyone with too much debt will either save or pay down their debt as a first choice. That can take years.
If the market for debt is limited and too much is borrowed by the government then the true rate of interest ill rise for every borrower because of competition for funds.
Central banks using interest rates to limit the demand for debt will be well aware of this. Central banks using the other method of managing the supply of credit (none are doing this at present as far as I know), will simply find that the true rate of interest is rising if there is greater demand for credit than there is supply. The result will be little different. A healthy economy needs to have affordable rates of true interest for the private sector.