About Sovereign Bonds

A sovereign bond is a bond issued by the national government of a country. Sometimes this type of bond is further subdivided into “government” bonds, issued in the national currency of the government in question, and true sovereign bonds, issued in other, foreign currencies. In most basic respects sovereign bonds are identical to other forms of bonds: they are, in essence, contracts under which a principal sum of money is loaned until a particular future repayment date, and interest on that principal is paid in the meantime. However, whereas private bond issuers may go bankrupt, governments which fall into severe political and economic straits may enter into the more complicated situation of sovereign default.

A bond is, in essence, a type of loan. (This makes them different from the other most common investment vehicle, stocks, which are shares in the ownership of a company.) A certain amount of money is loaned – the initial “purchase” price of the bond – and it is repaid at a future date, with interest accumulating in the meantime. The bond is the contract which specifies the amount of money to be loaned, the date at which it will be repaid, and the rate at which interest will accumulate in the meantime. The interest rates set are generally determined by the creditworthiness of the bond issuer, in much the same way as individuals’ home mortgage interest rates reflect their credit score. A bond issuer with a poor credit rating must offer higher interest rates in order to attract investors, who will fear that a shaky company may go bankrupt and fail to pay back some or all of the principal.

Sovereign bonds issued by governments share all of these basic principles with bonds issued by other organizations, including private corporations, other levels of government (municipal, state, and provincial bonds in various countries), and international financial institutions like the World Bank. They also have credit ratings assigned by the bond ratings companies, such as Standard & Poor’s (now owned by McGraw-Hill), Moody’s (MCO), and the Dominion Bond Rating Service (DBRS). These ratings range from Aaa (a spotless record with virtually no risk of default) through B, C, and D, implying progressively greater risk, up to the point that the government or corporation in question is almost guaranteed not to make its proper payments.

From the perspective of investors, the principal difference between corporate bonds and government or sovereign bonds is the greater capacity of governments to repay debts, and thus the lower level of risk associated with the bond. Corporations go bankrupt; governments, at least in theory, can raise sufficient taxes to pay off any debt – at least to the point that the populace is willing to pay these taxes rather than revolt, as the Greek government learned to its great discomfort in early 2010. At the same time, however, national governments are the highest authority in their country, and therefore cannot be forced by external creditors to actually repay their debts if they choose not to do so. For this reason, both paying off a bond on time and not paying off a bond on time are, for national governments, at least partially a political decision rather than a strictly financial or economic one.

When sovereign bonds are issued in foreign currency, it should also be noted, the risk is markedly higher than when government bonds are issued in that government’s own currency (for instance, U.S. government bonds denominated in U.S. dollars). This is because, at least in theory, a government can never involuntarily default on a government bond issued in its own currency. Governments which control their own currency (which was not the case in Greece, which uses the euro) can simply print new money to make payments as needed. The typical result is high inflation and political controversy – but this capacity to print money does mean that governments will never default on bonds issued in their own currency unless they choose to do so.

The situation is somewhat more complicated with respect to sovereign bonds issued in foreign currencies. Governments cannot print foreign currencies any more than corporate bond issuers can. In such cases, their capacity to repay a loan depends upon their capacity to raise tax revenue from the public, while simultaneously keeping the value of the national currency high enough to obtain a good currency exchange rate. If the value of the national currency falls precipitously while the government is attempting to raise substantial amounts of foreign money in order to pay off a bond, it may actually find itself unable to do so. Such currency problems played substantial roles in the wave of financial crises which rippled through eastern Asia in the late 1990s, as well as in the Argentine sovereign default of 2001. For this reason, developed countries with sufficient economic and monetary stability to attract investors in their own currency often prefer to issue government bonds in their own currency when they need to borrow money.