Understanding Sovereign Bond Yields: Risks & Rates

A sovereign bond yield is an interest rate that a national government pays to service its outstanding bonds. As with corporate bondsCorporate BondsCorporate bonds are issued by corporations and usually mature within 1 to 30 years. They usually offer a higher yield than government bonds but carry more risk., a sovereign bond yield depends on the inherent risk for the bondholders. However, the risk involves political risks, economic uncertainties, and exchange rates if the issued debt instruments are denominated in a foreign currency.

Summary

• A sovereign bond yield is the interest rate used by the national government to honor its debt obligations. 
• Sovereign bonds  issued domestically are risk-free assets and are used by governments to raise additional capital to fund budget items.
• Sovereign bond yields depend on the risks involved for their holders and are thus influenced by factors such as creditworthiness, political stability, and the exchange rate of the issuing government. 

Understanding Sovereign Bond Yields

Sovereign bond yields refer to interest rates that national governments use to service their debt obligation. Governments around the world prefer sovereign bonds as a way to address deficits in their national budget funding. Compared to other riskier bonds, sovereign bonds yield lower interest rates because credit riskCredit RiskCredit risk is the risk of loss that may occur from the failure of any party to abide by the terms and conditions of any financial contract, principally, is not built into their valuation.

Governments can always pay bonds on maturity by issuing more currency, which renders the sovereign bonds risk-free, as they are based on the issuing government. The risk premium imposed on corporations is often measured using the spread between highly-rated corporate bonds and sovereign bond yields. For the above reason, investing in foreign corporate bonds usually requires investors to pay detailed attention to the aforementioned factors.

Determinants of Sovereign Bond Yields

1. Creditworthiness of the Issuing Government

Creditworthiness is the perceived ability of a country or sovereign entity to honor its loan obligation in its current situation. Upon request, a credit rating agency, such as Moody’s Investor Services, can evaluate the economic growth and the political environment of a given country to assign it a credit rating, reflecting its likelihood of meeting a debt obligation in international bond markets.

2. Stability of the Issuing Government

A country’s political stability represents its sovereign risk, and it comprises factors that may arise to thwart its ability to honor debt obligation. For example, a volatile political environment can be an influencing factor for a country to default on its sovereign bonds.

3. Currency Exchange Market

The above factor relates to the country’s exchange rate, which usually affects sovereign bonds denominated in foreign currencies. Some countries use the exchange rate concept as a loophole for making their debts less valuable by issuing more currency.

Example of Sovereign Bond Default

The determinants of sovereign defaults, if not well balanced, can lead to sovereign bond default. For example, political instability or factors leading to economic upheavals may increase a government’s likelihood of defaulting on its debt obligations.

The most recent case of sovereign bond default involved Argentina in 2002 when it failed to honor its debt obligations following a recession in the late 1990s. The Argentinian government eventually defaulted because its currency was denominated in U.S. dollarsUnited States Dollar (USD)The United States Dollar refers to the national currency of the U.S and is represented by the ISO code USD and is often abbreviated as US$., making it difficult to inflate its way out of the debt.

External Imbalances and the Sovereign Bond Yield

Since the 2009 mortgage financial crisis, several European countries have realized a spectacular increase in their long-term sovereign bond yields. While core countries seem to have realized significant benefit from the flight-to-quality effect, others on the peripheral economy have borne the brunt of abrupt revision of market expectations.

The flight-to-quality concept refers to a market phenomenon where investors shift their asset allocationAsset AllocationAsset allocation refers to a strategy in which individuals divide their investment portfolio between different diverse categories from investments they perceive as risky to those considered safe, such as shifting from investing in stocks and moving into bonds.

In the abrupt revision of the market, a sovereign bond yield is, on average, relatively higher than suggested by the fiscal indicators’ deterioration. In this sense, the increase in rates can be explained by a combination of both external and internal imbalances. Such imbalances have been the source of widening differentials of sovereign bond yields among these countries.

Investors consider the imbalances abnormal since the increase in the default risk premium for the peripheral countries towards the end of the crisis coincides with the deterioration of their external imbalances. Conversely, interest rates tend to decrease in the core countries where foreign assets are held.

More Resources

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• Budget DeficitBudget DeficitA budget deficit occurs when government expenditures exceed revenues from taxes and other sources. It is most commonly applied to government budgets.
• Credit RatingCredit RatingA credit rating is an opinion of a particular credit agency regarding the ability and willingness an entity (government, business, or individual) to fulfill its financial obligations in completeness and within the established due dates. A credit rating also signifies the likelihood a debtor will default.
• Default Risk PremiumDefault Risk PremiumA default risk premium is effectively the difference between a debt instrument's interest rate and the risk-free rate. The default risk premium exists to compensate investors for an entity's likelihood of defaulting on their debt.
• European Sovereign Debt CrisisEuropean Sovereign Debt CrisisThe European Sovereign Debt Crisis refers to the financial crisis that occurred in several European countries as a result of high government