Manage sovereign debt risk

Sovereign debt is one of the oldest investment asset classes in the world. Governments have been issuing bonds for centuries, so the risks are well known. Today, sovereign debt is an important part of many institutional investment portfolios, and it is becoming more and more popular with individual investors. This article will examine the risks of sovereign debt and explain the technologies that investors can use to safely invest in this market.

Key points

  • A country with negative economic growth, heavy debt burden, weak currency, low taxation capacity, and unfavorable population structure may not be able to repay its debts.
  • The government may decide not to repay the debt, even if it is capable of doing so.
  • The credit ratings of countries are a good place to start studying sovereign debt risks.
  • Diversification is another major tool to prevent sovereign credit risks.
  • Mutual funds and exchange-traded funds are attractive options for investing in sovereign debt.

Types of sovereign debt

Sovereign debt can be divided into two major categories. Bonds issued by advanced economies such as Germany, Switzerland, or Canada usually have very high credit ratings. They are considered very safe and have relatively low yields.

Emerging market bonds issued by developing countries constitute the second largest category of sovereign debt. The credit ratings of these bonds are generally lower than those of developed countries, and may even be rated as junk. Because investors believe they are risky, emerging market bonds usually offer higher yields.

U.S. Treasury bonds are technically sovereign bonds, but this article focuses on evaluating sovereign bonds from issuers outside the United States.

General factors of sovereign debt risk

Ability to pay

The government’s ability to pay is a function of its economic status. A country with strong economic growth, a manageable debt burden, a stable currency, effective taxation, and a favorable demographic structure may be able to repay its debts. This ability is usually reflected in the high credit ratings of major rating agencies. A country with negative economic growth, heavy debt burden, weak currency, low taxation capacity, and unfavorable population structure may not be able to repay its debts.

Willingness to pay

The government’s willingness to repay debts usually depends on its political system or government leadership. The government may decide not to repay the debt, even if it is capable of doing so. Non-payments usually occur in countries with government changes or unstable governments. This makes political risk analysis an important part of investing in sovereign bonds. Rating agencies will consider willingness to pay and ability to pay when assessing sovereign credit.

The government may decide not to repay the debt, even if it is capable of doing so.

Specific sovereign debt risk

default

Investors should pay attention to many types of negative credit events, including debt defaults. When the borrower cannot or will not repay the debt, a debt default occurs. Bondholders do not receive predetermined interest payments during the default period, and they often fail to recover their entire principal. Bondholders usually negotiate with the government to obtain some value of their bonds, but this is usually only a small part of the initial investment.

Reorganization

Debt restructuring occurs when a government that is difficult to pay renegotiates bond terms with its creditors. These changes may include lowering interest rates, extending maturity periods, or reducing principal amounts. Debt restructuring is done to benefit the bond issuer and is therefore almost always detrimental to bondholders. The main exception is that the reorganization prevented the expected default.

Currency devaluation

The last negative development for bondholders is currency depreciation. Since technically this is not a default or other credit event, sovereign bond issuers are usually more willing to get rid of debt through inflation. When domestic consumers experience price increases, foreign investors must deal with currency depreciation. When the national government chooses inflation, the depreciation of foreign currency is usually greater than domestic inflation. When a country’s currency depreciates, foreign investors will face a reduction in interest payments and a reduction in principal calculated in their own currency.

Ways to prevent sovereign debt risks

Research credit rating

Investors can use a variety of tools to guard against sovereign credit risks. The first is research. By determining whether a country is capable and willing to pay, investors can estimate expected returns and compare them to risks. The credit ratings of countries are a good place to start studying sovereign debt risks. Investors can also use third-party sources, such as the Economist Intelligence Unit or the CIA World Factbook, to obtain more information about certain issuers.

diversification

Diversification is another major tool for preventing sovereign credit risks. Holding bonds issued by multiple governments in different regions of the world is a way to diversify the sovereign debt market. A single negative credit event of a government has limited impact on diversified investment portfolios. Investors can also diversify their currency depreciation risk by holding bonds denominated in multiple different currencies.

Bottom line

Sovereign debt can provide quite high security and relatively high returns. However, investors need to be aware that the government sometimes lacks the ability or willingness to repay debt. This makes research and diversification extremely important for international debt investors. In practice, it is difficult for most individual investors to conduct in-depth research on sovereign bonds and build a diversified investment portfolio. Mutual funds and exchange-traded funds are attractive options for investing in sovereign debt.

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