maturity of price-indexed bonds, that would lock in the cost of debt service at real interest
rates as high as 10% for many years ahead. In fact, this could be too high a cost for a
government fully determined to carry out the fiscal stabilization.
A role for nominal debt instruments of short duration emerges if the stabilization pro-
gram does not enjoy full credibility and long-term interest are too high relative to govern-
ment expectations of future rates. The decision of the Treasury to rely on bonds indexed
to the Selic rate clearly finds a strong motivation in this argument; floating-rate LFT debt
ensures that a fall in interest rates would be immediately transmitted into a lower debt
service cost. Although our analysis cannot capture such an effect, it points to fixed-rate
bonds with a one-year maturity as an attractive alternative to Selic-rate indexation.
Indeed, the third policy indication that emerges from this paper is to substitute fixed-
rate bonds for bonds indexed to the Selic rate. Fixed-rate debt avoids large interest pay-
ments when the Selic rate rises during a crisis or reacts to negative supply shocks and thus
when debt stabilization is endangered by slow output growth. We find evidence that issu-
ing fixed-rate bonds in exchange for Selic-indexed bonds increases the probability of debt
stabilization even if the 12-month term premium is as high as 4%. Since realistically the
maturity of fixed-rate bonds will have to remain relatively short, within two years, a greater
share of such bonds would not preclude the benefit of a fall in interest rates.
Issuance of fixed-rate bonds can bring additional benefits as they play a key role in
the creation of a domestic bond market. The resumption in 2003 of LTN auctions for
maturities longer than one year goes in the right direction. The Treasury should commit to
this strategy by announcing a regular program of fixed-rate bond auctions, since the success
of this strategy hinges on the market perception that the program will not be changed or
interrupted because of unfavorable market conditions.
20