Sovereign debt is one of the oldest investment asset classes in the world. National governments have been issuing bonds for centuries, so the risks are well-known. Today, sovereign debt forms a significant part of many institutional investment portfolios, and it is also increasingly popular with individual investors. This article will examine the risks of sovereign debt and explain techniques investors can use to invest in this market safely.

KEY TAKEAWAYS

  • A country with negative economic growth, a high debt burden, a weak currency, little ability to collect taxes, and unfavorable demographics may be unable to pay back its debt.
  • A government may decide not to pay back its debt, even if it has the ability to do so.
  • Credit ratings for countries are a good place to start researching sovereign debt risk.
  • Diversification is the other primary tool for protecting against sovereign credit risk.
  • Mutual funds and exchange-traded funds are attractive options for investing in sovereign debt.

Types of Sovereign Debt

Sovereign debt can be broken down into two broad categories. Bonds issued by developed economies, such as Germany, Switzerland, or Canada, usually carry very high credit ratings. They are considered extremely safe and offer relatively low yields.

Emerging market bonds issued by developing countries form the second broad category of sovereign debt. These bonds often carry lower credit ratings than the debt of developed nations, and they may even be rated as junk. Because investors perceive them as risky, emerging market bonds often provide higher yields.

U.S. treasuries are technically sovereign bonds, but this article focuses on evaluating sovereign bonds from issuers other than the United States.

General Factors in Sovereign Debt Risk

Ability to Pay

A government's ability to pay is a function of its economic position. A country with strong economic growth, a manageable debt burden, a stable currency, effective tax collection, and favorable demographics will likely have the ability to pay back its debt. This ability will usually be reflected in a high credit rating by the major rating agencies. A country with negative economic growth, a high debt burden, a weak currency, little ability to collect taxes, and unfavorable demographics may be unable to pay back its debt.

Willingness to Pay

A government's willingness to pay back its debt is often a function of its political system or government leadership. A government may decide not to pay back its debt, even if it has the ability to do so. Nonpayment usually occurs following a change of government or in countries with unstable governments. This makes political risk analysis a critical component of investing in sovereign bonds. Rating agencies take into account willingness to pay as well as the ability to pay when evaluating sovereign credit.

A government may decide not to pay back its debt, even if it has the ability to do so.

Specific Sovereign Debt Risks

Default

There are several types of negative credit events that investors should be aware of, including debt default. A debt default occurs when a borrower cannot or will not pay back its debt. Bondholders do not receive their scheduled interest payments during a default, and they frequently do not receive their full principal back either. Bondholders will often negotiate with a government to obtain some value for their bonds, but this is usually a fraction of the initial investment.

Restructuring

A debt restructuring occurs when a government having difficulty making payments renegotiates the terms of the bonds with its creditors. These changes can include a lower rate of interest, longer term to maturity, or a reduction of the principal amount. Debt restructuring is done to benefit the bond issuer, so it is almost always unfavorable for bondholders. The major exception is when a restructuring prevents an anticipated default.

Currency Depreciation

A final negative development for bondholders is currency depreciation. Because it is not technically a default or another credit event, sovereign bond issuers often prefer to inflate their way out of debt. While domestic consumers experience price inflation, foreign investors must deal with currency depreciation. Foreign currency depreciation is usually greater than domestic inflation when a national government chooses inflation. When a nation's currency falls in value, foreign investors face both lower interest payments and reduced principal in terms of their own currencies.

Ways to Protect Against Sovereign Debt Risk

Researching Credit Ratings

There are several tools that an investor can use to protect against sovereign credit risk. The first is research. By determining if a country is able and willing to pay, an investor can estimate the expected return and compare it with the risk. Credit ratings for countries are a good place to start researching sovereign debt risk. Investors might also use third-party sources, such as the Economist Intelligence Unit or the CIA World Factbook, to get more information about some issuers.

Diversification

Diversification is the other primary tool for protecting against sovereign credit risk. Owning bonds issued by several governments in different parts of the world is the way to achieve diversification within the sovereign debt market. A single negative credit event for one government will have a limited impact on a diversified portfolio. Investors can also diversify their currency depreciation risk by owning bonds denominated in several different currencies.

The Bottom Line

Sovereign debt can provide a combination of considerable safety and relatively high returns. However, investors need to be aware that governments sometimes lack the ability or willingness to pay back their debts. That makes research and diversification extremely important for international debt investors. In actual practice, it is difficult for most individual investors to conduct in-depth research on sovereign bonds and construct a diversified portfolio. Mutual funds and exchange-traded funds are attractive options for investing in sovereign debt.