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 financing government programs, paying down old debt, paying interest on current debt, and any other government spending needs. Sovereign bonds can be denominated in a foreign currency or the government’s domestic currency. Sovereign bonds are a source of government financing alongside tax revenue.

Understanding a Sovereign Bond

Like any bond, sovereign debt entitles owners to periodic interest payments from the issuer—in this case the government—as well as to the 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. For a sovereign bond, the yield will be higher for countries seen at higher risk of a default. Investors consider the economic profile of the country, its exchange rate, and politics to estimate the likelihood of a default on sovereign debt obligations.

Rating agencies including Standard & Poor's, Moody's, and Fitch Ratings provide sovereign credit ratings for investors seeking to understand the risks involved in investing in a specific country. These agencies also provide credit ratings on corporations and corporate debt securities.

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 exchange rate risk. Their currency markets may not be sufficiently liquid, or investors may not believe the currency will maintain its value because of inflation, 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 that in which the sovereign bond is denominated.

For example, say the Indonesian government issues bonds denominated in yen to raise capital. It agrees to a nominal annual interest rate of 5% but throughout 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 is 15% in rupiah terms.

Investing in Sovereign Bonds

Investing in U.S. sovereign bonds is fairly straightforward and can be done on TreasuryDirect.gov. Buying foreign bonds is a bit more tricky and is usually done via a broker through an account set up for foreign trading. The broker would typically buy the bond at the prevailing market price. This route can be limiting, depending on what bonds are available, and transaction costs could 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 may mitigate investment 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)