What are government & sovereign bonds? World Debt Crisis - Part 2

28 May 2010

(This is Part 2 of the series of articles on world debt crisis. Read part 1)
Governments with strong economies, who are well trusted in the world, are able to raise funds by issuing their own securities, usually called bonds. Individuals, other nations, and groups buy these bonds, and the government promises to pay them back at a certain, usually fairly good, interest rate.

Less robust governments, who do not have the trust from the world to be able to issue bonds and expect people to buy them, may turn to international institutions, or even normal banks, to give them loans, usually at less favorable rates.

Bond - Investor’s view
A bond is a debt investment in which an investor loans a certain amount of money, for a certain amount of time, with a certain interest rate, to a company.

Mechanism of buying/sellings of government securities
Treasury bills, notes and bonds are first sold at auction. This is called primary market. This means they can be bought for more or less than the face value, depending on demand. For example, when demand is high, bidders will pay more than face value. Bidders know Treasury bills, notes and bonds can be resold on the open market. This means their price can fluctuate further.
An investor can either hold a tradeable security until maturity or sell in the secondary market prior to maturity at the current market price.

Primary Dealers/Commercial Banks quote buying and selling prices of Treasury Bills, Treasury Bonds daily for different maturities. Investors can shop around and bargain to obtain attractive market rates for these securities.

Government bonds
A government bond is a bond issued by a national government denominated in the country's own currency.

The money for this type of debt is raised by selling government securities (in country's own currency) which includes;

•    Government/Treasury bonds- Investor loans a certain amount of money, for a certain amount of time (typically 2 to 20 years), with a certain interest rate issued by a national government denominated in the country's own currency
•    Government/Treasury Bills - Short term debt instrument of 3, 6 or 12 Months issued by the national government
•    Government/Treasury Notes - Very much similar to government bonds (typically mid term)

Government bonds/debt is part of internal debt of the country.

Government bonds are usually referred to as risk-free bonds, because the government can up to a point, raise taxes, reduce spending, or simply print more money to redeem the bond at maturity. Some counter examples do exist where a government has defaulted on its domestic currency debt, such as Russia in 1998 (the "ruble crisis"), though this is very rare.

Secondly, there is inflation risk, in that the principal repaid at maturity will have less purchasing power than anticipated if the inflation out turn is higher than expected. Many governments issue inflation-indexed bonds, which should protect investors against inflation risk.

Sovereign bonds
The term sovereign bond usually refers to bonds issued by a government in foreign currencies, while bonds issued by national governments in the country's own currency are referred to as government bonds. The total amount owed to the holders of the sovereign bonds is called sovereign debt.

Sovereign bonds/debt is part of external debt of the country.

Nations with very high or unpredictable inflation or with unstable exchange rates often find it uneconomic to issue bonds in their own currencies and so are forced to issue bonds denominated in more stable foreign currencies.

Investors in sovereign bonds denominated in foreign currency have the additional risk that the issuer may be unable to obtain foreign currency to redeem the bonds.

This raises the issue of sovereign default if the nation cannot afford to repurchase the necessary foreign currency at bond repayment time. Due to the risk of default, investors require the bonds to be issued with a higher yield.

In the event of default, unlike a corporation or even a municipal subdivision, a nation cannot file for bankruptcy. But on the rare occasions that a default occurs, just as in defaults on corporate bonds, recent practice has been that the defaulting borrower presents an exchange offer to its bond holders in an effort to restructure the sovereign debt, as has been the case in US dollar denominated bonds issued by Peru (1996) and Argentina  (2001).

The most resent sovereign default was reported early 2010 where vast majority of people of Iceland voted against in Icelandic debt repayment referendum which may effectively lead to default.
Greece and some other Euro zone countries are also now facing the risk of sovereign defaults.

Related articles:
- Understanding World Debt Crisis – Part 1

References
- Government debt (Wiki)
- External debt (Wiki)
- Internal debt (Wiki)
- Government bond (Wiki)
- Sovereign bond (Wiki)
- What are Treasury Bills, Notes and Bonds?
- Financial & Investment Dictionary:Public Debt (Answers.com)
- How to Invest in Treasury Bills and Bonds - Central Bank of Sri Lanka

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