What Is a Sovereign Bond?
A sovereign bond is a debt security issued by a national government to raise money for financing government programs, paying down old debt, paying interest on current debt, and any other government spending needs. Sovereign bonds can be denominated in a foreign currency or the government’s domestic currency. Sovereign bonds are a source of government financing alongside tax revenue.
- Sovereign bonds are debt securities issued by a government to raise capital for spending needs, such as on government programs and paying down debt.
- Sovereign bonds can be issued in the government's domestic currency or in a foreign currency.
- Riskier sovereign borrowers—those with a developing economy or higher political risk—tend to denominate sovereign bonds in the currencies of more stable economies.
- Foreign government bond exchange-traded funds (ETFs) offer a simple way to invest in the sovereign bonds of foreign issuers.
Understanding a Sovereign Bond
As with other bonds, the interest rate paid, or yield, depends on the risk profile of the issuer. For a sovereign bond, the yield will be higher for countries seen at higher risk of a default. Investors consider the economic profile of the country, its exchange rate, and politics to estimate the likelihood of a default on sovereign debt obligations.
Rating agencies including Standard & Poor's, Moody's, and Fitch Ratings provide sovereign credit ratings for investors seeking to understand the risks involved in investing in a specific country. These agencies also provide credit ratings on corporations and corporate debt securities.
Sovereign Bond Denominations
Some developing countries can't attract foreign investment in bonds denominated in their domestic currency because foreign investors are unwilling to assume the exchange rate risk. Their currency markets may not be sufficiently liquid, or investors may not believe the currency will maintain its value because of inflation, eroding their rate of return.
Countries borrowing in a foreign currency face similar currency exchange risk, and higher borrowing costs if the domestic currency loses value against that in which the sovereign bond is denominated.
For example, say the Indonesian government issues bonds denominated in yen to raise capital. It agrees to a nominal annual interest rate of 5% but throughout the bonds’ term the Indonesian rupiah depreciates by 10% annually versus the yen. As a result, the real interest rate on the yen-denominated debt to the Indonesian government is 15% in rupiah terms.
In August 2023, Fitch Ratings downgraded the long-term ratings of the United States to "AA+" from "AAA" due to the anticipated fiscal deterioration over the next three years, increasing government debt burden, and the erosion of governance related to 'AA' and 'AAA' rated peers over the last two decades that has resulted in repeat debt limit standoffs and 11th-hour resolutions.
Investing in Sovereign Bonds
Investing in U.S. sovereign bonds is fairly straightforward and can be done on TreasuryDirect.gov. Buying foreign bonds is a bit more tricky and is usually done via a broker through an account set up for foreign trading. The broker would typically buy the bond at the prevailing market price. This route can be limiting, depending on what bonds are available, and transaction costs could be high.
A simpler alternative is to buy U.S. mutual funds or exchange-traded funds (ETFs) that hold foreign sovereign bonds. These funds also provide diversification with exposure to a variety of foreign bond issues, which may mitigate investment risk.
Popular foreign sovereign bond ETFs include:
- iShares International Treasury Bond ETF (IGOV)
- SPDR Bloomberg International Treasury Bond ETF (BWX)
- SPDR Bloomberg Capital Short Term International Treasury Bond ETF (BWZ)
- Franklin Liberty International Aggregate Bond ETF (FLIA)
What Are Sovereign Bond Yields?
Sovereign bond yields are the interest rate the government pays to a buyer of a sovereign bond, which is a debt security issued by a national government to raise capital. Much like with corporate debt, sovereign bond yields depend on the level of risk for the buyer.
How Are Sovereign Bonds Denominated?
Sovereign bonds, which are debt securities issued by national governments to raise money, can be denominated in either the local currency or in a global currency, such as the U.S. dollar or the euro.
Are Sovereign Bonds Risky?
The risk of a sovereign bond is no different than any other bond — it is at risk of the issuer defaulting. Sovereign bonds issued by countries with low ratings tend to have higher political, economic, currency, or other risk and have a higher chance of defaulting. Sovereign bonds issued by countries with high ratings are more stable politically, economically, and otherwise, and have a low risk of default.
The Bottom Line
A sovereign bond is a debt security issued by a national government for the purpose of financing spending programs, such as infrastructure programs, social programs, war efforts, or other spending programs. Much like corporate debt, the riskiness of sovereign debt depends on the likelihood of the underlying issuer of the debt being in default. For countries with higher political and economic risk, the likelihood of default may be high. But for countries that are more stable, the risk is relatively low.