An investor's guide to sovereign risk for pricing bond returns (Part 1 of 10)
Knowledge and sovereign risk investments
Overseas government bonds, or sovereign bonds, can provide investors with a source of stable income. Due to differences in economic cycles and monetary policies across countries, they can also provide valuable diversification benefits to your bond portfolio.
Despite their obvious benefits, certain sovereign bonds are more reliable than others. You should exercise caution in your investment choices. Otherwise, an unsuspecting investor might end up holding high-risk debt issued by Argentina or Greece. Both countries have had a colorful history of default. You can also invest in very high-quality debt at little risk. This may be a source of stable returns.
Types of sovereign bonds
Sovereign bonds may be issued by governments of developed market (EFA), emerging market (EEM), and frontier market economies. Countries are classified as developed, emerging, or frontier markets depending on their stage of economic and financial sector development.
Sovereign bonds may be denominated in the local currency of the issuing country or a foreign currency. For example, the government in South Korea may issue bonds in either the Korean won or a foreign currency like the U.S. dollar.
In this series, you’ll read about the risks in sovereign bond investments and the key drivers of these risks. You’ll also read about the factors that affected Argentina and Greece’s sovereign debt defaults. The factors caused stress in the debt payments of countries like Spain, Portugal, and Italy.
Credit ratings matter
Most countries are also rated by credit ratings agencies (or CRAs) like Standard & Poor’s (MHFI), Moody’s Investor Services (MCO), and Fitch Ratings. The credit ratings provided by MCO for a few select countries, their market classification, and the degree of riskiness is provided in the above table.
Depending on their credit profile, country ratings are broadly categorized as investment-grade and non-investment grade. There are rating levels within the broad framework. The interest rate that issuers pay in the international market would generally be based on ratings provided by the above-mentioned CRAs. The higher the rating, the lower the yield and vice-versa.
Investment-grade sovereign bonds (PCY) are issued by governments that exhibit a high ability and willingness to honor their debt obligations. As a result, they carry lower risks and also lower yields—for example, the U.S., Germany, and Japan.
Non-investment grade sovereign bonds are issued by governments that are believed to have a lower ability and willingness to pay their debt obligations. These bonds receive low ratings from CRAs because they are higher risk investments. As a result, they also pay higher rates of interest—for example, Argentina, Greece, and Portugal.
Returns and risks
You can read more about the returns from sovereign bonds and their associated risks in the next part of the series.
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