A sovereign bond is a debt security issued by a national government. Sovereign bonds can be denominated in a foreign currency or the government’s domestic currency; the ability to issue bonds denominated in domestic currency tends to be a luxury that most governments do not enjoy — the less stable of a currency denomination, the higher the risk the bondholder's faces.
Breaking Down Sovereign Bond
The government of a country with an unstable economy tends to denominate its bonds in the currency of a country with a stable economy. Because of default risk, sovereign bonds tend to be offered at a discount.
The default risk of a sovereign bond is assessed by international debt markets and represented by the yield the bond offers. Bondholders demand higher yields from riskier bonds. To illustrate, as of May 24, 2016, 10-year government bonds issued by the Canadian government offer a yield of 1.34%, while 10-year government bonds issued by the Brazilian government offer a yield of 12.84%. This spread of 1150 basis points accounts for the financial position of both governments and is indicative of the favorable credibility enjoyed by the Canadian government.
Sovereign Bonds Denominated in Foreign Currencies
As of 2014, the most recent year such data is available, debt denominated in the five most significant global currencies, the U.S. dollar, the British pound, the euro, the Swiss franc, and the Japanese yen, accounted for 97% of all debt issuance, but these countries issued only 83% of this debt. The reality is less-developed countries have difficulty issuing sovereign bonds denominated in their currency, and thus have to assume debt denominated in a foreign currency.
This is due to several reasons. First, investors consider poorer countries to be ruled by less-transparent governments that are more susceptible to corruption, increasing the likelihood of loans and government investments being funneled into unproductive areas. Second, poorer countries tend to suffer from instability, leading to higher rates of inflation, which eats into the real rates of return received by investors.
Therefore, less-developed countries are forced to borrow in foreign currencies, further threatening their economic situation by exposing them to currency fluctuations that can make their borrowing costs more expensive. For example, say the Indonesian government issues bonds denominated in yen to raise capital. If the interest rate it agrees to borrow is 5%, but throughout the bonds’ maturity, the Indonesian rupiah depreciates by 10% in relation to the yen. Then, the real interest rate the Indonesian government has to pay in the form of principal and interest payments is 15%, assuming its business operations are conducted in rupiah.