Compared to stocks and corporate bonds, investors tend to think of government debt as a kind of safety blanket for their portfolio. While companies can go bankrupt and leave borrowers in the lurch, political leaders wouldn’t let that happen to a government liability, right?

In fact, countries can, and periodically do, default on their debt. This happens when the government is either unable or unwilling to make good on its fiscal promises. Argentina, Russia and Pakistan are just a few of the governments that have defaulted over the past couple decades.

Of course, not all defaults are the same. In some cases, the government actually misses an interest or principal payment. Other times, it simply delays a disbursement. The government can also exchange the original notes for new ones with less favorable terms. Here, the holder either accepts lower returns or takes a “haircut” on the loan – that is, accepts a bond with a much smaller par value.

Table 1

Partial list of countries that have defaulted since 1999.

Country

Default Year(s)

Duration of Default

Ecuador

2008-2009

6 months

Grenada

2004-2005

11 months

Paraguay

2003-2004

18 months

Argentina

2001-2005

54 months

Indonesia

2000

6 months

Pakistan

1999

11 months

Russia

1999-2000

22 months

Factors Affecting Risk

Historically, failure to make good on loans is a bigger problem for countries that borrow in a foreign currency. Why? Because when they face a budgetary shortfall, such nations don’t have the option to simply print more money.

The fact that many developing countries issue bonds in an alternate currency – often the U.S. dollar – helps explain why wealth plays such a big part in default risk. According to The World Bank, the probability of public debt default among all countries with a high gross national income per capita is 7%, compared to 17% for countries with low gross national income per capita. There are exceptions to this general rule, however.

Despite their relatively high per-capita income, some eurozone countries face the same limitation. Even with multiple foreign bailouts, Greece has forced private bondholders to take significant haircuts of up to 74%.

The nature of a country’s government also plays a major role in credit risk. Research suggests that the presence of checks and balances leads to fiscal policies that maximize social welfare – and honoring debt carried by domestic as well as foreign investors certainly does that. Conversely, governments where certain political groups hold a disproportionate power level can lead to reckless spending and eventually default.

With the ability to print their own money, countries like the United States, Great Britain and Japan would appear immune to a debt default. This isn’t quite the case, however. Despite a stellar record overall, the United States has technically defaulted a few times throughout its history. In one instance in 1979, the Treasury temporarily missed payments on $122 million in debt because of a paperwork error. And even if the government is able to pay its debts, legislators may not be willing to do so, as periodic clashes over the debt limit remind us.

It’s also important to remember that investors can take a haircut on government debt, even if the nation hasn’t officially defaulted. Whenever the country's treasury has to print more money to meet its obligations, the country’s total money supply increases and each dollar in circulation loses some of its value.

Mitigating Risks

When a country defaults on its debt, the impact on bondholders can be severe. In addition to punishing individual investors, it impacts pension funds and other large investors with substantial holdings.

One of the ways that institutional investors can protect themselves against catastrophic losses is through a contract known as a credit default swap. The contract seller agrees to pay any remaining principal and interest should the nation go into default. In exchange, the buyer pays a period protection fee, which is similar to an insurance premium. The protected party agrees to transfer the original bond, which may have some residual value, to its counterpart should a negative credit event take place.

While originally intended as a form of protection, swaps have also become a common way to speculate on a country's credit risk. As such, many of those trading credit swaps don't have positions on the underlying bonds that they reference. For example, an investor who thinks the market has overestimated Greece's credit problems could sell a contract and collect premiums, confident of having no one to reimburse.

Because credit default swaps are relatively sophisticated instruments and trade over-the-counter, getting up-to-date market prices is difficult for typical investors. This is one of the reasons they are typically used by institutional investors with more extensive market knowledge and access to special computer programs that capture transaction data.

Economic Impact

Just as an individual who misses payments has a harder time finding affordable loans, countries that default – or risk default, for that matter – experience substantially higher borrowing costs. Agencies such as Moody’s, Standard & Poor’s and Fitch are responsible for rating the debt quality of countries around the world based on their financial and political status. In general, nations with a higher credit rating enjoy lower interest rates.

When a country actually does default, it can take years to recover. Argentina, which missed bond payments beginning in 2001, is a perfect example. By 2012, the interest rate on its bonds was still more than 12 percentage points higher than that of U.S. Treasuries.

Perhaps the biggest concern about a default, however, is the impact on the broader economy. In the U.S., many mortgages and student loans are pegged to Treasury rates. If borrowers were to experience dramatically higher payments as the result of a debt default, the result would be substantially less disposable income to spend on goods and services.

Because the contagion can spread to other economies, countries with close ties – and especially those that own much of the debt – will sometimes step in to avert a default. This happened in the mid-1990s when the United States helped bail out Mexican bonds. And in the wake of the 2008 global recession, the International Monetary Fund, European Union and European Central Bank provided Greece with much-needed liquidity.

The Perfect Time to Invest?

Where some investors look at a financial crisis and see chaos, others recognize an opportunity. They believe that default represents a bottom point – or something close to it – for government bonds. And, for a “glass half full” kind of investor, the only direction these bonds can go is up.

In fact, a number of so-called “vulture funds” specialize in precisely this kind of activity. Much like a debt collection agency buying personal credit accounts on the cheap, these funds purchase government bonds for a fraction of their original worth.

Because of the economic fallout that usually occurs after a default, investors frequently start hunting for undervalued stocks as well. Certainly, investing in such countries comes with its fair share of risk, as there’s no guarantee that a rebound will ever take place. Those seeking security in their portfolio above all else will probably want to look elsewhere.

Yet recent historical examples are encouraging for a more growth-oriented investor. For instance, within the past few decades, equity markets in Russia, Brazil and Mexico increased substantially in the wake of a bond crisis. The key is to look for companies with competitive advantages and a low price-to-earnings ratio that reflects their elevated risk level.

The Bottom Line

There have been numerous government defaults over the past few decades, especially in countries that borrow in a foreign currency. When this happens, the government’s bond yields rise precipitously, creating a ripple effect throughout the domestic or even world economy.

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