Understanding and Investing in Sovereign Bonds

What Is a Sovereign Bond?

A sovereign bond is a debt security issued by a national government to raise money for its operations, pay down old debt, pay interest on current debt, and for any other government spending needs. Sovereign bonds may be denominated in a foreign currency or the government’s domestic currency.

Sovereign bonds are a major source of government financing, alongside tax revenue. They are a safe investment or a risky one depending on the financial health of the nation that issued them.

Understanding a Sovereign Bond

Like any bond, sovereign debt entitles owners to periodic interest payments from the issuer—in this case the government—with repayment of the bond's face value when its term matures.

As with other bonds, the interest rate paid, or yield, depends on the risk profile of the issuer. The yield will be higher for countries that are seen to be at a higher risk of default.

Rating agencies grade sovereign bonds based on the economic profile of the country, its exchange rate, its outstanding debts, and its political stability to estimate the likelihood that it could default on its sovereign debt obligations.

Rating agencies including Standard & Poor's, Moody's, and Fitch Ratings provide sovereign credit ratings for investors seeking to evaluate the risks involved in investing in a specific country. The same agencies provide credit ratings on corporations and the bonds they issue.

Sovereign Bond Denominations

Some developing countries can't attract foreign investment in bonds denominated in their domestic currency because foreign investors are unwilling to assume the additional risk of a fluctuating currency. Their currency markets may not be sufficiently liquid, or investors may be wary that the currency will lose value, eroding their rate of return.

Countries borrowing in a foreign currency face similar currency exchange risk and higher borrowing costs if the domestic currency loses value against the one in which the sovereign bond is denominated.

For example, say the Indonesian government issues bonds denominated in the Japanese yen to raise capital. It agrees to a nominal annual interest rate of 5%. During the bonds’ term, the Indonesian rupiah depreciates by 10% annually versus the yen. As a result, the real interest rate on the yen-denominated debt to the Indonesian government will be 15% in rupiah terms.

Investing in Sovereign Bonds

Investing in U.S. sovereign bonds is a straightforward process and can be done on the U.S. Treasury Department site, TreasuryDirect.gov.

Buying foreign bonds is a bit trickier and is usually done via a broker through an account set up for foreign trading. The broker would buy the bond at the prevailing market price. This route can be limiting, depending on what bonds are available, and the transaction costs can be high.

A simpler alternative is to buy U.S. mutual funds or exchange-traded funds (ETFs) that hold foreign sovereign bonds. These funds also provide diversification with exposure to a variety of foreign bond issues, which reduces risk.

Popular foreign sovereign bond ETFs include:

• iShares International Treasury Bond ETF (IGOV)
• SPDR Bloomberg International Treasury Bond ETF (BWX)
• SPDR Bloomberg Capital Short Term International Treasury Bond ETF (BWZ)
• Franklin Liberty International Aggregate Bond ETF (FLIA)

The Bottom Line

A sovereign bond may be issued by a national government to finance infrastructure programs, social programs, a war, or any other spending. As with corporate debt, the riskiness of sovereign debt depends on the likelihood of the underlying issuer defaulting. For countries with higher political and economic risk, the likelihood of default may be high. But for stable countries, the risk is low.