Sovereign and supranational bonds

In short

A friend of mine once asked me why her retirement fund held a bond issued by something called the World Bank, and she was a little worried it might be a trick. It is no trick, and she was right to ask. A sovereign bond is a loan to a national government, and a supranational bond is a loan to an agency owned by several governments together. Each one is a promise to pay interest and return your money on a set date. The safety of the promise depends on who made it, in what currency, and how long the clock runs. Read the credit rating, the currency, and the maturity before anything else. Weigh what a bond pays against what it costs you in fees and taxes. And look at the bond's own documents, because they say who is bound to pay.

The whole of it

What it is

I grew up around people who understood borrowing in a plain way. A neighbor lends you a plow, and you give it back. Governments borrow too, only the plow is a bridge or a payroll, and the neighbor is a mutual fund or a pension. When a national government sells a bond, we call it a sovereign bond. The United States sells Treasury securities. Germany sells Bunds. Mexico, Japan, and Brazil sell their own.

If you are holding a fund with a line that reads World Bank or European Investment Bank, you hold a supranational bond. A supranational is an agency owned by many countries together. The World Bank is one. The Asian Development Bank is another. They borrow in the bond market and lend the money on for roads, schools, and clean water. Their member governments stand behind them, and that backing is a large part of why investors trust them.

A friend of mine calls the coupon the paycheck of a bond, and he is close to right, since it is the yearly interest, usually paid in two halves. Both return the face value at maturity, which is the date the loan ends. Simple enough. The care comes in knowing who is making the promise.

How it works

If you have ever lent money to a relative, you know the first question is whether they can pay you back. A bond works the same way. Rating agencies such as S&P Global Ratings, Moody's, and Fitch Ratings grade the borrower. A higher grade means the agency thinks repayment is more likely. A lower grade means more risk, and the borrower must pay a higher interest rate to attract lenders.

I once knew a man who bought a foreign bond and never asked what money it paid in, and that is where currency comes in. A bond sold in dollars by a foreign government pays you in dollars. A bond sold in that country's own money pays you in that money. If the foreign currency loses value against the dollar, your payback shrinks when you convert it. Many a careful person has been surprised by this one.

If you have ever tried to sell a used truck in a hot market, you know that price moves too. When market interest rates rise, older bonds with lower coupons lose value if sold early. When rates fall, they gain. The longer the maturity, the bigger the swing. Hold to maturity and the swing does not change what the borrower owes you, though you may still face other risks along the way.

A banker I once talked with said one more piece trips up many folks. A government that borrows in its own currency can, in principle, create that currency to pay. A government that borrows in a foreign currency cannot. That difference has shaped many a hard season for a country. It is worth knowing even if you never buy a single bond.

The numbers, and where to find yours

I like to tell people to check the paper before the pitch. For a bond or a bond fund, the paper is the prospectus, a document that lays out the terms, the risks, and the costs. Funds publish one, and the Securities and Exchange Commission keeps them on its EDGAR database, which anyone may search for free.

If you are standing in front of a bond for the first time, the number to find first is the yield to maturity, which is the total yearly return if you hold to the end. Next is the expense ratio of any fund, which is the yearly fee taken from your balance. Then the credit rating, the currency, and the maturity date.

For United States Treasury securities, TreasuryDirect, run by the Treasury Department, lists current offerings and how to buy them directly. The tax picture has its own set of numbers. Interest from Treasury securities is taxed by the federal government but, by law, not by state or local governments. Check the official Internal Revenue Service guidance on this. Interest from foreign bonds may be taxed differently, and the foreign country may withhold some of it. A friend of mine who held foreign bonds learned that the foreign tax credit has a yearly cap set by law, and the cap is the current figure, which the official source publishes each year. The IRS explains the credit and the current rules in its guide called Foreign Tax Credit for Individuals, known as Publication 514.

A worked example

A neighbor of mine, Dolores Whitfield, is sixty one and has $40,000 she wants in something steady. She finds a supranational bond fund and a short Treasury note. Her goal is simple. She wants to know what each costs her in a year.

Dolores started with the fee, since she had been burned by one before. The fund charges an expense ratio of 0.20 percent. On $40,000, that is $40,000 times 0.0020, which is $80 a year. The fund yields 4.0 percent before fees. Four percent of $40,000 is $1,600. After the $80 fee, she keeps $1,520.

Dolores, like many of us, saved the tax question for last. She is in the 22 percent federal bracket. Interest from the supranational fund is taxable federally. Twenty two percent of $1,520 is $334.40. So her after tax income from the fund is $1,520 minus $334.40, which is $1,185.60.

The Treasury note is another story. Suppose it yields 3.8 percent with no fund fee. Three point eight percent of $40,000 is $1,520. Federal tax at 22 percent is $334.40, the same. But Dolores lives in a state that taxes income, and Treasury interest is exempt from state tax. If her state rate is 5 percent, she would have owed $76 on $1,520, and the exemption saves her that. On the fund she pays the state tax, so her real after tax fund income is $1,185.60 minus $76, which is $1,109.60.

Her Treasury note gives her $1,520 minus $334.40, which is $1,185.60, with no state bite. The two paths land $76 apart. Neither is wrong. She simply sees the cost clearly now, and the choice stays hers.

Where it goes wrong

I once watched a good man chase a high yield on a foreign bond without asking why it was so high. The answer was risk. A high yield is the market telling you the borrower may struggle to pay. That is the first place things go wrong.

A cousin of mine learned the second lesson the hard way, and it is about currency. A bond can pay every coupon on time and still lose you money if the foreign currency falls. The third is the fee that hides in a fund. Small percentages add up over twenty years, and nobody feels them until later.

Fourth, a country can default, meaning it fails to pay as promised. Some have, and the terms get reworked, often with losses to the lender. Supranationals have a strong record, but a record is not a guarantee. Fifth, tax rules differ by country, and a foreign government may withhold a share before the money reaches you. Missing that step on a tax return costs people real dollars.

Nobody here is at fault for finding this tangled. It is tangled. Slow down.

Questions to answer before you leave this page

Do you know who is making the promise on the bond you are looking at, and what the rating agencies say about that borrower? Is the bond paid in dollars or in another currency, and can you stand it if the exchange rate swings the wrong way? When does the loan end, and would a rise in interest rates before then trouble you? What does the fund charge each year, and have you multiplied that by your balance to see the dollars? Have you read the prospectus on the SEC's EDGAR database, or the offering terms on TreasuryDirect? And have you looked at the IRS guidance, including Publication 514, to learn how the interest will be taxed where you live?