What You Should Know About Sovereign Bonds

Have you ever wondered how governments raise money to finance infrastructure projects, social programs, or other spending measures when tax revenue isn't enough?

National governments issue debt securities known as sovereign bonds, which can be denominated in either local currency or global reserve currencies, like the U.S. dollar or euro. In addition to financing government spending programs, these bonds can be used to repay older debts that may be maturing or cover interest payments coming due. 

In this article, we'll take a look at some important concepts to know when it comes to sovereign bonds (such as yields, ratings, and credit risk), as well as how investors can purchase them.

Sovereign Bond Yields

Sovereign bond yields are the interest rate the governments pay on their debt. Like corporate bonds, these bond yields depend on the risk involved for the buyers. Unlike corporate bonds, these risks primarily include the exchange rate (if the bonds are priced in the local currency), economic uncertainties, and political risks that can lead to a possible default on the interest payments or principal.

Here's a quick summary of the three major determinants of sovereign bond yields:

• Creditworthiness - Creditworthiness is the perceived ability of a country to repay its debts given its current situation. Often, investors rely on rating agencies to help determine a country's creditworthiness based on growth rates and other factors.
• Country Risk - Sovereign risks are external factors that may arise and jeopardize a country's ability to repay its debts. For instance, volatile politics could play a role in raising the risk of a default in some cases if an irresponsible leader takes office.
• Exchange Rate - Exchange rates have a substantial effect on sovereign bonds denominated in local currencies. Some countries have inflated their way out of debts by simply issuing more currency, making the debt less valuable.

Sovereign Bond Ratings

Standard & Poor's, Moody's, and Fitch are the three most popular providers of sovereign bond ratings. While there are many other boutique agencies, the "big three" rating agencies carry the most weight among global investors. The upgrades and downgrades made by these agencies can lead to significant changes in sovereign bond yields over time.

Sovereign bond ratings are based on several factors, including:

• Per Capita Income
• Gross Domestic Product Growth
• Inflation
• External Debts
• History of Defaulting
• Economic Development

Sovereign Bond Defaults

Sovereign bond defaults aren't common, but they have happened many times in the past. One of the most recent major defaults was in 2001 when Argentina wasn't able to repay its debt after a recession in the late 1990s. Since the country's currency was pegged to the U.S. dollar, the government couldn't inflate its way out of its problems and ultimately defaulted.

Two other popular examples were in Russia and North Korea. Russia defaulted on its sovereign bonds in 1998 and shocked the international community, who assumed that major world powers wouldn't default on their debt. And in 1987, North Korea defaulted on its debts after mismanaging its industrial sector and spending too much money on its military expansion.

Buying Sovereign Bonds

Investors can buy sovereign bonds through a variety of channels. U.S. Treasury bonds can be purchased directly through the U.S. Treasury, via TreasuryDirect.gov, or within most U.S. brokerage accounts. However, buying foreign sovereign bonds can be significantly more difficult for investors based in the U.S., particularly if they want to use U.S. exchanges.

Foreign issued sovereign bonds are easiest purchased via exchange-traded funds (ETFs). Sovereign bond ETFs enable investors to purchase sovereign bonds in an equity form that can be easily traded on U.S. stock exchanges. These diversified ETFs typically hold a number of bonds at various maturities and provide a more stable investment than individual sovereign bonds.