What Is Sovereign Bond Yield?
Sovereign bond yield is the interest rate paid on a government (sovereign) bond. In other words, it is the rate of interest at which a national government can borrow. Sovereign bonds are sold by governments to investors to raise money for government spending, including financing finance war efforts.
- Sovereign bonds are issued by governments to raise capital.
- Sovereign bonds are considered risk free assets.
- Credit ratings are based on GDP, history, income, inflation, other debt, and various other factors.
- Countries sometimes borrow in other currencies if their currency is too weak.
Understanding Sovereign Bond Yield
Sovereign bonds, like other bonds, yield the full face value at maturity. Sovereign bonds are the number one way that governments fill in budgeting gaps. Because many sovereign bonds are considered risk-free, such as U.S. Treasury securities, they do not have credit risk built into their valuation, and therefore yield a lower interest rate than riskier bonds.
The spread between sovereign bond yields and highly-rated corporate bond yields is often used as a measure of the risk premium placed on corporations. It is important to consider all of these factors together when considering an investment in sovereign or corporate bonds.
Technically, sovereign bonds are considered risk-free because they are based on the currency of the issuing government, and that government can always issue more currency to pay the bond on maturity. However, when this does happen, the bond loses value and yields drop. Factors that affect the yield of a specific sovereign bond include the creditworthiness of the issuing government, the value of the issuing currency on the currency exchange market, and the stability of the issuing government. In 2008, American bond yields dropped despite America being the one that caused the financial crisis.
Always remember that there is no such thing as “zero-risk” in investing and this includes sovereign bonds.
The creditworthiness of sovereign bonds is typically based on the perceived financial stability of the issuing government, and its perceived ability to repay debts. International credit rating agencies often rate the creditworthiness of sovereign bonds—notably Moody’s, Standard & Poor’s, and Fitch. These ratings are based on factors that include:
- Gross domestic product (GDP) growth
- The government’s history of defaulting
- Per capita income in the nation
- The rate of inflation
- The government’s external debts
- Economic development within the nation
When a government is experiencing political instability or suffering from external factors that contribute to instability, there is a risk that the government could default on its debts. During the sovereign debt crises that have occurred in the past decades, the market began pricing in a credit premium and this increased the cost of new borrowing for these governments. Recent examples include the European debt crisis and crises in Russia and Argentina.
Japan’s current debt-to-GDP ratio, where many countries have debts that are more than double their GDP.
Even without credit risk, sovereign bond yields are influenced by currency exchange rate risk, and local interest rates. This is especially true if governments borrow in a foreign currency, such as a country in South America borrowing in dollars because devaluation of their domestic currency could make it harder to repay the debt. Borrowing in another currency is typically something done by countries with currencies that are not very strong on their own.