An investor's guide to sovereign risk for pricing bond returns (Part 4 of 10)
Economic edge in the UK, Brazil, and India
Well-developed banking and financial systems, currency convertibility, and effective monetary policy are some of the other factors that determine sovereign debt (PCY) risks. You’ll read about some of the major factors in this section.
A stable political regime is one of the most important factors that determines sovereign risk. The ability to institute fiscal reforms through the legislative framework is also important to access international debt markets. Credit markets would look more favorably on such borrowers.
For example, Cuba with a communist, single-party form of government, has a lower credit rating—Caa2, Moodys—on its debt compared to Brazil—Baa2, Moody’s. Brazil has a democratically elected government. Brazil also has a well-developed stock market (EWZ) and strong financial institutions.
Monetary policy is one of the key determinants of local currency interest rates. The ability of the central bank to control local debt markets through the base rate, open market operations, and reserve requirements would instill greater confidence among international sovereign debt investors. The UK has a well-developed central banking tradition that’s similar to the U.S.
Well-developed stock and bond markets are very important determinants of liquidity—the ability to buy and sell securities as required. These factors instill greater confidence in the international investing community. For example, the iShares MSCI EAFE ETF (EFA) includes equities from developed market countries, excluding the U.S. and Canada.
The iShares MSCI EMU Index (EZU) includes holdings in 11 developed market countries within the European Monetary Union. These countries have well-developed stock and bond markets and credible banking institutions.
Young, working age, educated, and skilled populations are one of the key factors that affect future economic growth and government tax collections. If favorable investments are made, these would likely widen the government tax base and provide a steady revenue stream in the coming years. Countries like India are in this category.
Favorable demographics work for stock market investments. A young working-age population is good for current and future consumption. Most of the holdings of the WisdomTree India Earnings ETF (EPI) are invested in companies that are incorporated and traded in India.
Sovereign debt crises
The sovereign debt crises in Argentina, Greece, Portugal, Spain, and Italy in recent years were caused by a combination of these factors. You’ll read how in next part of the series.
Browse this series on Market Realist: