The elephant in everybody's room has the same color: the color of debt. The 2007-2009 financial crisis was caused by it, but the response -- record-low interest rates and financial repression -- has only fattened the debt elephant even more.

In advanced economies, the average level of public debt has increased from around 70% of gross domestic product before the crisis to almost 110% last year, according to data from the International Monetary Fund (IMF). The situation is so bad that even a mild recession could trigger a big shock.

The downgrade by Moody's of China's sovereign credit rating one notch to A1 from Aa3 illustrates the increasing unease among experts at the pace of growth of debt in the world's second-largest economy.

Investors in fixed income have enjoyed big returns thanks to central banks; they have pushed yields, which move inversely to bond prices, to historic lows by buying sovereign and corporate bonds in their attempt to stop deflationary trends in some areas of the major economies.

But as that tactic is nearing the end -- even central banks cannot buy the whole of a country's debt -- investors should prepare for other ways in which sovereigns will try to cope with their increased debt burdens. One of these, which is under discussion more and more -- mainly in expert circles, at least for now -- is the GDP-linked bond.

There are very few real-life examples of such bonds. Some have been issued by countries dealing with debt problems; Greece, for instance, issued a kind of GDP-linked debt instrument during its restructuring of debt in 2012. A workshop in November 2015 at the Bank of England discussed, among other things, "why these instruments do not exist already".

Image placeholder title

GDP-linked bonds work on the same principle as inflation-linked bonds. In one hypothetical example, the principal payment is indexed to the level of nominal GDP, thus giving investors in effect an "equity stake" in the country. Because the coupon payment is fixed as a percentage of the principal, the coupon is also linked to GDP.

(Curious investors can read more about how they work in this term sheet for a fictitious country's GDP-linked bond, published by the Bank of England in March.)

For the issuer, GDP-linked bonds help to contain the debt burden, because, as the IMF economist Alex Pienkowski explained in a recently published working paper, they "adjust in value in the face of shocks to output, helping to stabilize the debt-to-GDP ratio." In other words, the deeper the recession, the smaller (or nonexistent) the payout. The faster the expansion, the bigger the coupon investors get.

Pienkowski developed a model that shows that these bonds raise the percentage of debt to GDP that advanced and emerging economies can take on before they are in danger of defaulting. In a world where many countries are fast approaching -- or have even exceeded -- that limit, these bonds could help unlock further economic growth.

In Pienkowski's model, the debt limit beyond which default risks occur is 137% of GDP for advanced economies and 98% for emerging markets, assuming that the debt is 100% denominated in local currency. If 20% of that debt were to consist of GDP-linked bonds, the default risk limit would rise to 152% of GDP for advanced economies' debt and to 106% for emerging markets.

For a 50% GDP-linked debt composition, the default risk threshold increases to 175% of GDP for advanced economies and to 120% for emerging ones. If all debt were GDP-linked, whoo-hoo! -- advanced countries could borrow 238% of their GDP before risking default, while emerging ones, 140%.

What About Investors?

These instruments sound like a great solution to the debt crisis that keeps threatening the world; they're almost like a magic trick. For governments, they're insurance against downturns. For central banks, they relieve pressure on their monetary policy, as they would be able to raise interest rates without the risk of triggering sovereign defaults.

But what about investors? Well, they would need to look very carefully at these instruments before touching them. First of all, they are new. And yes, I know that ETFs were relatively new in 2007 and look where we are now. But arguably, ETFs are in essence just the repackaging in a cheaper form of already-existing instruments. These GDP-linked bonds would be starting from scratch.

Second, investors should wait until credit rating agencies issue in-depth analysis of such instruments (if they have not already; if you're a rating agency reading this and have such analysis that you can share, click on my byline to send me an email). At least then you'd have some expert literature to rely on. This should not be too difficult, as rating agencies already analyze complicated debt instruments with equity components, such as convertible bonds or additional tier one bonds issued by banks to fill their regulatory capital buffers.

And third, well, ultimately the price is everything. Such GDP-linked bonds would be a great way to get good returns when the economy is growing. But unlike traditional bonds, which must pay investors their coupon and repay the principal at the end no matter what, in a downturn bondholders would suffer almost as much as the equity crowd.

Traditional bonds are priced on the basis of the cash flows investors receive, and these cash flows are fixed no matter what the economy is doing -- unless the issuer defaults, in which case they stop dry. Finding the right premium investors should request for uncertain cash flows will be the tricky part, but not impossible, as inflation-linked bonds successfully have shown.

At the end of the day, you know what these GDP-linked bonds are: a soft form of debt forgiveness. Personally, I have long argued in favor of it, not just for troubled sovereigns but also for households. At a fair price for investors, it could be achieved. The global economy would benefit from it.

(One last word, and a bit of promo for Real Money's products: Until these instruments do get launched, investors seeking to diversify from plain vanilla sovereign bonds ought to take a look at our Income Seeker portfolio, which combines fixed-income investing strategies with dividend investing.)

This article originally appeared at 10:00 ET on Real Money, our premium site for active traders. Click here to get great columns like this from Jim Cramer and other writers even earlier in the trading day.

Employees of TheStreet are restricted from trading individual securities.