Sovereign debt is one of the oldest investment asset classes in the world, as national governments have been issuing bonds for centuries. Today, sovereign debt forms an important cornerstone of many institutional investment portfolios and is becoming increasingly popular with many individual investors. This article will examine the sovereign debt market, and explain techniques investors can use to safely invest in this market.
What is Sovereign Debt?
Sovereign debt can be broken down into two broad categories. Bonds issued by large, developed economies (such as Germany, Switzerland or Canada) usually carry very high credit ratings, are considered extremely safe and offer relatively low yields. The second broad category of sovereign debt encompasses bonds issued by developing countries - often referred to as emerging market bonds. These bonds often carry lower credit ratings than developed nation sovereigns, and may actually be rated as junk. Because they are perceived as being riskier, emerging market bonds often provide higher yields. U.S. treasuries are technically a sovereign bond, but this article will focus on evaluating sovereign bonds from issuers other than the United States; in other words, international government bonds from the perspective of a U.S.-based investor.
Why Invest in Sovereign Debt
Because they are issued by national governments, sovereign bonds are generally among the safest investments in most countries (although, this is all relative – sovereign bonds issued by Venezuela may be safer than Venezuelan stocks, but this does not necessarily make them safe). This makes sense for several reasons:
1. Countries want to be able to continue borrowing, so they generally make a high priority of paying back debt.
2. Even if countries are not particularly credit worthy, their sovereign bonds are usually safer than other domestic alternatives. In a scenario where the government is defaulting on its debt, it is unlikely that the country's other stocks, bonds or currency markets are doing well. (For more, see Playing It Safe In Foreign Stock Markets.)
In addition to being relatively safe, sovereign debt can also produce impressive returns. In the case of high-quality developed market bonds, relatively low yields during normal times can turn into very high returns during times of market stress, when these bonds usually perform well in a "flight to quality." Because they are generally riskier, emerging market sovereign bonds often offer higher returns than developed nation bonds. In fact, emerging market sovereign bonds have produced equity-like returns at times in the past (with commensurately high volatility, of course).
One final benefit U.S.-based investors will find with sovereign bonds is that adding them to a diversified portfolio will help add international exposure and diversify a portfolio away from the United States. Thus, investors can benefit (or lose) in two ways from sovereign bonds: interest and capital gains (or losses) from the bond itself, and currency movements relative to the U.S. dollar.
Risks from Sovereign Debt
A government's ability to pay is a function of its economic position. A country with a strong economy, manageable debt burden, stable currency, strong tax collection and positive demographics will likely have the ability to pay back its debt. This ability will usually be reflected in a strong credit rating by the major ratings agencies. On the other hand, a country with a weak economy, high debt burden, weak or volatile currency, little ability to collect taxes and poor demographics may find itself in a position where it is unable to pay back its debt.
A government's willingness to pay back its debt often is 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. This usually occurs following a change of government or in countries with unstable governments. This makes political risk analysis an important component of investing in sovereign bonds. Importantly, ratings agencies take into account willingness to pay as well as ability to pay when evaluating sovereign credits.
Negative Credit Events for Sovereign Investors
There are several types of negative credit events that investors should be aware of, up to and including a debt default. A debt default occurs when a borrower (in this case, a government) can't (or won't) pay back its debt. In this case, bondholders no longer receive their scheduled interest payments, nor do they receive their principal on maturity. Bondholders will often negotiate with a government to receive some value for their bonds, but this is usually cents on the dollar, and rarely approaches 100% of the initial investment.
A debt restructuring occurs when a government anticipates difficulty in repaying its debt as planned, and therefore comes to an agreement with bondholders in order to renegotiate the terms of the bonds. These changes can include a lower rate of interest, longer term to maturity or reduced principal amount. These restructurings are done to benefit the bond issuer and are almost always negative for bondholders (except to the degree that they prevent a default.)
A final negative development for bondholders is inflation. Because it is not technically a default or other credit event, issuers that can't (or won't) pay back their scheduled debts sometimes prefer to inflate their way out of the problem. From a bondholder's perspective though, high inflation results in principal and interest payments that carry less value (from a purchasing power perspective) than they initially planned for.
Ways to Protect Against Sovereign Risk
There are several tools that an investor can use to protect against sovereign credit risk. The first is research. By carefully analyzing a country's ability to pay and determining if it is likely to have the willingness to pay, an investor can properly analyze whether the expected return is in line with the risk being taken. Investors might also examine credit ratings for a country, as well as 3rd-party research tools, such as the Economist Intelligence Unit or CIA World Factbook, for more information about some issuers.
Diversification is the other primary tool for protecting against sovereign credit risk. By owning bonds issued by a variety of governments in different regions of the world, an investor can cushion his portfolio against the impact that a negative credit event by any single government might have. Investors can also diversify their currency exposure by owning a variety of bond issues denominated in several different currencies.
The Bottom Line
Depending upon the issuer, sovereign debt can provide safety, relatively high returns or a combination of both. However, investors need to be aware that governments sometimes lack the ability or willingness to pay back their debts as scheduled, making research and diversification extremely important for international debt investors. Because it might be difficult for many individual investors to conduct in-depth research on a variety of sovereign credits and construct a large enough portfolio to achieve proper diversification, mutual funds and exchange-traded funds are attractive options for investing in sovereign debt.