Sovereign Bond

What Is a Sovereign Bond?

A sovereign bond is a debt security issued by a national government to raise money for financing government programs, paying down old debt, paying interest on current debt, and any other government spending needs. Sovereign bonds can be denominated in a foreign currency or the government’s domestic currency. Sovereign bonds are a way governments raise money in addition to tax revenue.

Understanding a Sovereign Bond

A sovereign bond functions as a regular bond in that the purchaser of the bond receives periodic interest payments from the issuer, in this case, the government, and receives the repayment of the bond's face value when the bond matures.

Like any bond, the interest rate paid, or yield, depends on the risk profile of the issuer. For a sovereign bond, if the country is considered risky, then the yield will be higher. Investors consider the economic profile of the country, its exchange rate, and the political risks to determine the likelihood of a country defaulting on its debt obligations.

Rating agencies, such as Standard & Poor's, Moody's, and Fitch Ratings, provide sovereign credit ratings for investors to understand the risks involved in investing in a specific country. These agencies also provide credit ratings on corporations and their debt securities.

Sovereign Bond Denominations

The ability to issue bonds denominated in a domestic currency tends to be a luxury that most governments do not enjoy; the less stable of a currency denomination, the higher the risk the bondholder faces. The reality is that less-developed countries have difficulty issuing sovereign bonds denominated in their currency, and thus have to assume debt denominated in a foreign currency.

This is due to several reasons. First, investors consider poorer countries to be ruled by less-transparent governments that are more susceptible to corruption, increasing the likelihood of loans and government investments being funneled into unproductive areas. Second, poorer countries tend to suffer from instability, leading to higher rates of inflation, which eats into the real rates of return received by investors.

Therefore, less-developed countries are forced to borrow in foreign currencies, further threatening their economic situation by exposing them to currency fluctuations that can make their borrowing costs more expensive.

For example, say the Indonesian government issues bonds denominated in yen to raise capital. If the interest rate it agrees to borrow is 5%, but throughout the bonds’ maturity, the Indonesian rupiah depreciates by 10% in relation to the yen, then, the real interest rate the Indonesian government has to pay in the form of principal and interest payments is 15%, assuming its business operations are conducted in rupiah.

Investing in Sovereign Bonds

Investing in U.S. sovereign bonds is fairly straightforward and can be done on TreasuryDirect.gov. Buying foreign bonds is a bit more tricky and is usually done via a broker through an account set up for foreign trading. The broker would typically buy the bond at the prevailing market price. This route can be limiting, depending on what bonds are available, and transaction costs could be high.

A simpler alternative is to buy U.S. mutual funds or exchange-traded funds (ETFs) that hold foreign sovereign bonds. These funds also provide diversification with exposure to a variety of foreign bonds, which reduces the investment risk.

A list of popular foreign sovereign bond ETFs is as follows: