Though not common, countries can, and periodically do, default on their sovereign debt. This happens when the government is either unable or unwilling to make good on its fiscal promises to repay its bondholders. Argentina, Russia, and Pakistan are just a few of the governments that have defaulted over the past decades.

Of course, not all defaults are the same. In some cases, the government misses an interest or principal payment. Other times, it merely 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.

Key Takeaways

  • Sovereign default is a failure of a government to honor some or all of its debt obligations.
  • While uncommon, countries do default when their national economies weaken, when they issue bond denominated in a foreign currency, or a political unwillingness to service debts.
  • Countries are often hesitant to default on their debts, since doing so will make borrowing funds in the future difficult and expensive.

Factors Affecting Default Risk

Historically, failure to make good on loans is a bigger problem for countries that borrow in a foreign currency instead of using their own. Many developing countries issue bonds in an alternate currency in order to attract investors – often denominated U.S. dollars – but borrowing in another currency plays a significant role in default risk. The reason is that when a country that borrows foreign currency faces a budgetary shortfall, it does not have the option to print more money.

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 is a component of maximizing social welfare. Conversely, governments that are composed of certain political groups with 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 appear immune to a sovereign default, but this is not necessarily the case. Despite a stellar record overall, the United States has technically defaulted a few times throughout its history. In 1979, for instance, the Treasury temporarily missed interest payments on $122 million of debt because of a clerical error. Even if the government can pay its debts, legislators may not be willing to do so, as periodic clashes over the debt limit remind us.

Investors can thus experience a loss on government debt, even if the nation has not officially defaulted. Whenever a country's Treasury must print more money to meet its obligations, the country’s total money supply increases, creating inflationary pressure.

Mitigating Risks

When a country defaults on its debt, the impact on bondholders can be severe. In addition to punishing individual investors, defaulting impacts pension funds and other large investors with substantial holdings. One way that institutional investors can protect themselves against catastrophic losses is through a hedging strategy known as a credit default swap (CDS). With a CDS, the contract seller agrees to pay any remaining principal and interest on a debt 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 occur.

While originally intended as a form of protection or insurance, swaps have also become a common way to speculate on a country's credit risk. Many of those trading CDS, in other words, do not 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 and be confident that there is no one to reimburse.

Because credit default swaps are relatively sophisticated instruments and trade over-the-counter (OTC), getting up-to-date market prices is difficult for typical investors. This is one of the reasons only institutional investors use them, as they come 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. Ratings agencies such as Moody’s, Standard & Poor’s, and Fitch are responsible for evaluating the credit quality of countries worldwide based on their financial and political outlook. In general, nations with a higher credit rating enjoy lower interest rates and thus cheaper borrowing costs.

When a country 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. If a country has defaulted even once, it becomes harder to borrow in the future, and so low-income countries are particularly at risk. According to Masood Ahmed, a former senior executive at the IMF and now president of the Center for Global Development, as of Oct. 2018, of the 59 of the countries that the IMF classifies as low-income developing countries, 24 were in a debt crisis or at the edge of one, which is almost 40% and double the number in 2013.

Perhaps the biggest concern about a default, however, is the impact on the broader economy. In the United States, for instance, 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 of fear of contagion can spread to other economies, countries with close ties – particularly those that own much of the country's debt – will sometimes step in to avert an outright default. This happened in the mid-1990s when the United States helped to bail out Mexican bonds. Another example in the wake of the 2008 global financial crisis occurred as the International Monetary Fund (IMF), European Union (EU), and European Central Bank (ECB), came together to provide Greece with much-needed liquidity and credit stabilization.

After Default: The Perfect Time to Invest?

Whereas some investors look at a financial crisis and see chaos and losses, others recognize a crisis as a potential opportunity. These investors believe that sovereign default represents a bottoming out point – or something close to it – for government bonds. For the optimistic investor, the only logical direction for these bonds is up.

A number of so-called “vulture funds” specialize in precisely this type of bond buying activity. Much like a debt collection agency buys personal credit accounts at a low cost, these funds purchase defaulted government bonds for a fraction of their original worth. Because of the broader economic fallout that follows a sovereign default, investors frequently seek to pick up undervalued stocks in that country as well.

Investing in defaulting countries comes with its fair share of risk, of course, because there is no guarantee that a rebound will ever take place, and the larger issues that caused the default in the first place may still persist or are yet to be fully worked out. Those seeking security in their portfolio above all else should probably invest elsewhere. However, recent historical examples are encouraging for the 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, particularly by countries that borrow in a foreign currency. When default occurs, the government’s bond yields rise precipitously creating a ripple effect throughout the domestic, and often the world, economy.