sovereign bonds and country risk

In short

A friend of mine once asked why one country's bond pays so much more than another's, and I told him the lender is asking for a bit of comfort. If you are holding a sovereign bond, you have lent money to a national government, and you are counting on it to pay you back. Some governments have a long record of paying on time. Some do not. The extra interest a riskier country pays is the price of the worry. A country's credit rating, its debt load, and the currency its bonds are paid in are all public, and anyone can look them up. The currency is worth a look first, because a bond paid in a foreign currency carries a second risk on top of the first.

The whole of it

What it is

I once watched a neighbor lend a good sum to his brother in law, and the whole family held its breath until the first payment came. A sovereign bond is something like that, only the borrower is a national government. The lenders are people like you and me, along with banks and pension funds. The government sells the bond, receives the money, and promises to pay interest on a schedule. At the end of the term, it promises to hand back the original amount, called the principal.

Country risk is the chance that the borrower will not keep that promise in full or on time. It comes in a few forms. The most obvious is default, where a government stops paying some or all of what it owes. A softer form is restructuring, where the government asks lenders to accept later payment dates or smaller payments. A third is currency risk, which matters when the bond pays in a currency other than the buyer's own. A fourth is inflation, which can shrink what the money will buy even when every payment arrives.

Not every government faces the same worry. A country that borrows in its own currency can, in theory, create more of that currency to pay its debts. That lowers the chance of a plain default, but it can push prices up. A country that borrows in a foreign currency cannot print that money, so it must earn it or find it somewhere. Harder spot, that one.

How it works

You have probably noticed that safer borrowers pay less interest. That is the heart of it. Lenders compare a bond to a benchmark, which is the yield on debt from a government seen as very safe. The gap between the two is called the spread. A wider spread means lenders want more pay for carrying more worry.

Credit rating agencies give each government a letter grade that sums up its ability to repay. Three big ones are Standard and Poor's, Moody's, and Fitch Ratings. Their scales differ a little in wording, but each splits bonds into two broad groups. The higher group is called investment grade, and the lower group is often called high yield or speculative. When a country's rating falls, its bond prices often fall, and its yields rise. Price and yield move in opposite directions, like two ends of a seesaw.

Here is the part that surprises people. The interest paid is only part of the result. If a holder sells the bond before it ends, the price may be above or below what was paid, and that price moves with interest rates, with the country's standing, and with the mood of the market. A holder who keeps the bond to the end receives the principal back, as long as the government pays.

Currency adds another layer. Say a woman in the United States buys a bond that pays in euros. Each payment arrives in euros, and the plan has to turn them into dollars. If the euro slips against the dollar, her dollar result shrinks, even though the bond paid every cent it promised. Quiet, but real.

The numbers, and where to find yours

Most of what a reader wants to know costs nothing to find. The U.S. Department of the Treasury publishes daily yield curve rates for its own bonds, and that gives a benchmark to measure against. The International Monetary Fund publishes data on government debt, deficits, and economic output for its member countries. The World Bank offers debt statistics for many lower income countries. The Bank for International Settlements publishes data on international banking and debt. The rating agencies post their grades and the reasons behind them, though some of the detail sits behind a login.

Three numbers tell a great deal. The first is the debt to output ratio, which compares what a government owes with what its economy produces in a year. The second is the share of the government's budget that goes to interest payments. The third is the share of its debt that is owed in foreign currency. A country with high debt, high interest costs, and a lot of foreign currency debt faces the most strain.

If you buy through a U.S. broker, the bond's page shows four items worth reading. They are the currency, the maturity date, the coupon, and the credit rating. The coupon is the yearly interest rate set when the bond was issued. Write those four down before anything else. If a fund holds the bonds, its own documents show which countries and currencies it holds.

A worked example

A woman I will call Margaret has $10,000 to lend. She looks at two bonds that each last ten years. The first is from a government with a strong record, and it pays 4 percent a year. The second is from a country with a shakier record, and it pays 7 percent a year.

On the safer bond, 4 percent of $10,000 is $400 a year. Over ten years, $400 times 10 is $4,000 in interest. On the riskier bond, 7 percent of $10,000 is $700 a year. Over ten years, $700 times 10 is $7,000 in interest. The spread between the two is 7 percent minus 4 percent, or 3 percent. That extra 3 percent, which is $300 a year on her $10,000, is what she is paid for the added worry.

Now suppose the riskier country runs into trouble in year five. It asks lenders to take a 40 percent cut on the principal. Forty percent of $10,000 is $4,000, so her $10,000 would come back as $6,000. She has already collected five years of interest at $700 a year, which is $3,500. Her total back is $6,000 plus $3,500, which is $9,500. That is $500 less than she lent, even after all that extra interest.

Compare the safer bond. If it pays in full, she gets $10,000 back plus $4,000 in interest, for $14,000. The riskier bond would have given $10,000 plus $7,000, or $17,000, had it paid in full. So the riskier bond offered $3,000 more in the good case and left her $500 short in the bad case. The extra interest was a real payment for a real chance of loss. Nobody can say which case would have come true. This is a made up story with plain figures, and a real default can end in many different ways.

Where it goes wrong

A friend of mine once chased a high yield because it looked like free money. It never is. A high yield is a warning label as much as a reward. The market is saying that other lenders see a bigger chance of trouble.

People also forget the currency. A bond can pay every dollar of interest on time and still lose money for a buyer, if the currency it pays in falls. That is a quiet loss. It does not show up as a missed payment.

Another mistake is leaning on a rating as if it were a promise. Ratings are opinions, and agencies have been slow to change them before. A rating is a useful clue, but it is no guarantee. The debt numbers deserve a look of their own.

Concentration is a further trap. If all of a person's bonds come from one country or one region, a single bad turn can hit everything at once. Spreading across many borrowers lowers that risk, though it does not remove it.

Last, a friend of mine learned the hard way that the fine print on where a bond was issued matters. The law that governs a bond affects what a lender can do after a default. Each bond's documents name the law that governs it, and that choice sets which courts hear a dispute if the government stops paying. The documents for a bond or a fund list the governing law and the holdings, so that is where a reader can find it.

Questions to answer before you leave this page

Do you know which currency your bond pays in, and which currency your bills are paid in? If the two differ, have you thought about what a fall in the foreign currency would do to your result? Can you name the credit rating on the bond, and the agency that gave it? Have you looked at the country's debt to output ratio on the International Monetary Fund's site? What share of that country's debt is owed in foreign currency, and does that worry you? How much extra interest are you being paid over a benchmark from the Treasury, and is that spread wide enough to cover the risk as you see it? Would a 40 percent cut on the principal, as in Margaret's story, change your plans? Is there a date by which you will want this money back, and what price might the bond fetch if that date comes early? Have you put too much of your savings with one country? Can you explain, in a sentence or two, why this bond pays what it pays?