An investor's guide to sovereign risk for pricing bond returns (Part 2 of 10)
Risks of BRICS and developed market investments
As a bond investor, you must receive a fair return on your investment. Returns on your investment should be equal to the risks that it took to earn them. Pricing risks must be done correctly.
Most bond investments are subject to credit risk and interest rate risk. Credit risk is the risk of the borrower defaulting on the amount borrowed. Interest rate risk implies changes in the value of bond prices due to changes in interest rates. Bond prices move opposite to interest rates. An increase in interest rates would cause prices to decline and vice-versa.
The unique risks present in sovereign bonds
Besides interest rate risk, sovereign bonds may also be subject to country risk, currency risk ,and sovereign risk.
What is country risk?
Country risk is the risk to investments that comes from the country’s economic and political environment. The U.S. is widely viewed as having the lowest country risk in the world. Some countries have higher country risks compared to others. For example, stocks in emerging market countries like Brazil (EWZ), India, and China (FXI) would have higher country risk than those in developed market countries like Germany and Japan (EWJ).
Why currency risk should be avoided
Sovereign bond investments (PCY) may be denominated in U.S. dollars or the local currency. When U.S. dollars are denominated, there’s zero currency risk for a U.S. investor. Currency risk occurs when the bonds are denominated in foreign or local currencies. It’s the risk of lower returns due to adverse currency movements.
International currency movements follow a random walk hypothesis—they have poor predictive movements. Your investments would have lower volatility in dollar terms if sovereign bond investments (EMB) are denominated by U.S. dollars.
Country and currency risks also affect stocks. Exchange-traded funds (or ETFs) that are impacted by country and currency risks include the iShares MSCI Brazil Capped ETF (EWZ), the iShares MSCI Japan ETF (EWJ), and the iShares China Large-Cap ETF (FXI).
What’s sovereign risk?
Sovereign risk is the risk that a foreign government will fail to make timely payments on debt or actually default on its debt obligations. Sovereign risk is the same as credit risk for non-governmental borrowers. Please refer to the previous section for local and foreign currency ratings for the selected countries.
In the next part, we’ll discuss the key drivers of sovereign risks.
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