What is a Sovereign Bond?
A sovereign bond is a national government-issued debt security to finance spending programs, cover interests due, or repay old debts. As with other types of bonds, a sovereign bond promises to pay the buyer periodic interest and repay the face value on the maturity date. Its rating is associated with its creditworthiness.
A sovereign bond can be issued in either local currency or foreign currencies. However, most developing countries prefer issuing foreign currency-denominated over domestic currency-denominated sovereign bonds because of the high risk levels that bondholders face, especially in countries whose domestic currencies are less stable.
- A sovereign bond is a national government-issued instrument of indebtedness to support spending.
- It can be dominated in local currency or foreign currency, depending on the risk a bondholder is likely to face.
- Developing countries have difficulty in issuing sovereign bonds denominated in their currencies because of weak political systems that lower investor confidence.
Sovereign Bond Explained
A sovereign bond is essentially a commitment by the national government to make coupon payments and repay the bond’s face value on the maturity date. Countries with volatile economies and high inflation rates tend to issue their bonds in denominations that bear the currency of other countries with stronger economies.
Although sovereign bonds are often discounted because of the default risk, countries with less stable economies issue their sovereign bonds with high interest rates due to their perceived high risk of default.
The interest rate charged depends on three primary factors – the creditworthiness of a country, potential risks that may disrupt the economy, and exchange rates.
Yields from Sovereign Bonds
The risk of default of a sovereign bond is determined by international debt markets. Generally, the yield from a sovereign bond corresponds to its risk of default. Due to the high yields associated with riskier bonds, sovereign bonds from countries with a high default risk continue to be on-demand in the open market.
The yield on risky bonds issued in the domestic market is also much higher than returns realized from holding external foreign bonds. Governments with histories of serial default or limited resources represent higher default risk.
However, risk-averse investors tend to shoulder the risk of such governments with the expectation of earning a higher return. On average, the yields on risky bonds are significantly higher than those realized from the less-risky external sovereign bonds.
Foreign-Currency Denominated Sovereign Bonds
Foreign Currencies from Developed Economies
Countries with developed economies account for the largest portion when it comes to the issuance of sovereign bonds in international capital markets. The debt securities are mostly denominated in the six most popular currencies for trading, including the U.S. dollar, the euro, the Japanese yen, the British pound, the Canadian dollar, and the Swiss franc.
The above foreign currencies combined account for most of the debt issuance. The reality is that developing countries do not issue debt denominated in their currency because of the difficulty they face in issuing sovereign bonds. Instead, developing economies need to assume foreign-currency debt.
Foreign Currencies in Developing Economies
Several reasons explain why most of the emerging markets and developing economies are unable to issue sovereign bonds in their own currency.
The political system in most developing countries wanes investor confidence because of their vulnerability to corruption. The lack of fiscal discipline and government ineffectiveness increase the chances of external debts and government investments being utilized in unnecessary projects.
Additionally, such countries perennially suffer from economic instability, leading to high inflation rates, which absorb the investors’ real rates of return. International agencies, such as the International Monetary Fund (IMF), may also come in as determinants of external lending to developing countries. Such complimentary lending programs can serve as a seal of approval, catalyzing private capital flows and reassuring investors.
Even so, developing countries are forced to obtain external debts in foreign currencies, further subjecting them to a precarious economic situation by exposing the devaluation of currencies that can drive up their borrowing costs.
Risks Associated with Sovereign Bonds
1. Currency Risk
Currency risk materializes when the bondholder’s reference currency is higher than the currency that the sovereign bond is denominated in following a currency devaluation. Exchange rate fluctuation serves as the main source of currency risk. Any sovereign bond offering foreign currency with a history of volatility may not be a good deal for investors even if the debt instrument offers a high interest rate.
2. Credit Risk
Credit risk is realized when the government chooses to default on sovereign bonds denominated in its currency. A government bond issued in local currency is considered a risk-free bond because the government can opt to create additional currency if it so decides.
3. Interest Rate Risk
Like other debt instruments, sovereign bonds are subject to interest risk. The direction of interest rates and bond prices is inversely proportional – a fall in interest rate leads to an increase in bond price and vice versa.
4. Inflation Risk
Inflation risk comes from the overtime decline of the value held by a sovereign bond. Usually, investors anticipate a certain level of inflation, but when higher than expected, inflation risk arises.
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