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What are Sovereign Bonds?

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Sovereign bonds are debt securities issued by national governments. These bonds can be denominated in either local currency or a global currency, like the U.S. dollar or euro. The proceeds from these bond sales are used to fund a government's day-to-day operations, as well as to repay older debts that are maturing.

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 risks involved for the buyers. These risks primarily include the exchange rate (if the bonds are priced in local currency) and sovereign 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 times, investors rely on ratings agencies to determine this creditworthiness for them.
  • 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.
  • Exchange Rate - Exchange rates have a large effect on sovereign bonds denominated in local currencies. In fact, 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" ratings 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.

Sovereign bond ratings depend 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 in the past. The most recent major default was in 2002 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.

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 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.

Some Tips to Remember

  • Sovereign bonds are debt securities issued by national governments in either a local currency or an international currency, like the U.S. dollar or euro.
  • Sovereign bond yields are primarily affected by creditworthiness, country risk and exchange rates.
  • Sovereign bond ratings are typically issued by Standard & Poor's, Moody's, and Fitch, and provide investors with an idea of a sovereign bond's risk.
  • Investors can purchase sovereign bonds easiest through exchange-traded funds traded on U.S. exchanges.

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