Sovereign Bonds & Default Risk
As with corporate bonds, bonds from sovereign issuers also carry default risk. Each sovereign issuer has a common short name that is used in the market. For example, the U.S. issues Treasuries, the U.K. issues Gilts, and Germany issues Bunds. The French even issue Oats. When you buy a sovereign bond you are essentially lending the government money that will be paid back to you at a later date. As with corporate bonds, between the date of purchase and maturity you will receive regular interest payments followed by a repayment of principal. And like corporate bonds, most sovereign debt is rated by one or more of the ratings agencies.
Bonds issued by developed economies tend to have a higher credit rating than emerging market sovereign bonds. This is intuitive as more stable governments would be expected to be more reliable borrowers. When evaluating sovereign debt it is important to consider the political and economic climate of the issuer. If the country in which you own sovereign bonds is facing some kind of strife or turmoil, it may be unwilling or unable to pay back its debt. This can lead to a decline in bond price, non-payment of coupons, and even a loss of principal if there is a default. Sometimes countries will attempt to restructure their debt, leaving the bondholder with lower interest and principal payments, and sometimes extended maturity dates. Sovereign bonds can be issued in local or foreign currency, and fluctuating currency values can have a major impact on your total return.
To help investors think about and evaluate sovereign risk, BlackRock has developed the BlackRock Sovereign Risk Index (BSRI). The index ranks the level of credit risk in each sovereign issuer by looking at their fiscal position, willingness to pay, external financial position, and financial sector health. Click here or on the graphic below for the most recent scores and rankings.
Matt Tucker, CFA, is the iShares Head of Fixed Income Strategy and a regular contributor to The Blog. You can find more of his posts here.