What are sovereign bonds and how do they work?

Bonds issued by governments and corporations are a secure investment that enables bondholders to grow their money without the risk of losing their capital. One type of bond you can invest in is a sovereign bond, which is a type of government bond issued by a foreign government.

In this blog, we’ll explain sovereign bonds, how they work, and how to invest in sovereign bonds.

What are sovereign bonds?

Sovereign bonds are debt securities issued by a government. By buying sovereign bonds, you lend that government money that they use to fund various expenditures, social service programs, and debt restructuring.

Since sovereign bonds are backed by a government and its ability to tax, it is considered a low-risk investment. This type of bond has virtually zero default risk and is only sensitive to a few risks related to the country’s economic and political stability. This type of bond has short-term to long-term maturity periods, with terms ranging from 5 to 25 years.

However, they also offer lower yields than other types of investments. However, bonds offer consistent coupon payments.

How do sovereign bonds work?

Here are key characteristics of sovereign bonds to help you understand how they work:

• Yield: the returns investors can expect to earn upon the bond’s maturity.
• Maturity: the length of time between the issue date of the bond and its expiration, after which the bondholder receives the principal and yield.
• Coupon rate: also known as the interest rate, which is the amount the issuer agrees to pay the bondholder. This is expressed in percentage.
• Coupon payment: the periodic payments bondholders receive until the bond’s maturity.
• Credit rating: this reflects the government’s creditworthiness; higher credit ratings mean a lower risk of default.

Governments issue sovereign bonds to raise money, so when you invest in these bonds you are lending money to that government. In exchange for the money, the issuer pays you back the principal amount plus interest after a predetermined period.

Governments work with investment banks like Metrobank to help them manage and market the sovereign bonds to potential investors.

Throughout the bond’s term, the bondholder receives regular coupon payments. Then, upon maturity, they’ll receive the principal.

Bondholders may also elect to trade sovereign bonds through the secondary market if they want to liquidate them before maturity.

Types of sovereign bonds

Fixed-rate sovereign bonds

These types of bonds pay a fixed interest rate made annually or semi-annually. It offers stability and a steady source of income for bondholders. However, this type of bond offers lower yields due to the low risk associated.

Inflation-linked sovereign bonds

This type of bond is designed to protect your capital and earnings against inflation risk. The bondholder’s principal and interest payments are adjusted according to the Consumer Price Index (CPI). By doing this, the sovereign bond’s income maintains its purchasing power until maturity.

Zero-coupon sovereign bonds

Zero-coupon sovereign bonds do not give out regular coupon payments. Instead, investors buy the bond at a discounted rate to its face value. The bondholder receives the full face value upon maturity.

The investor’s income comes from the difference between the discounted rate and the face value.

Floating-rate sovereign bonds

Floating-rate sovereign bonds have variable interest rates, so coupon payments may fluctuate according to a benchmark reference rate. Although this type of bond is less predictable than fixed-income bonds, it enables investors to hedge against interest rate risk.

Foreign currency-denominated sovereign bonds

Sovereign bonds are usually denominated in the issuing country’s currency, but some governments issue bonds denominated in foreign currencies to take advantage of stronger currencies. This type of bond is sensitive to currency risk or fluctuations in exchange rates.

For example, the Republic of the Philippines have issued bonds denominated in US dollars, Japanese yen, and the euro.

How to buy sovereign bonds?

Sovereign bonds are bought and sold in the primary and secondary markets.

The primary market involves the investment banks that manage the sovereign bonds for the issuing governments. Potential investors may purchase sovereign bonds through their brokerage account or broker. They can either participate in auctions or purchase directly from the bank.

In the secondary market, sovereign bonds are traded between investors. These are also done through brokers. Bonds are usually sold by bondholders in the secondary market when they want to liquidate the investment.

Risks associated with sovereign bonds

While sovereign bonds are relatively low risk, investing in them comes with some type of risk. These factors affect the performance and value of sovereign bonds:

Country risk

Issuing governments receive a credit rating that indicates the risk of them defaulting on their debt. Credit ratings consider the country’s debt-to-GDP ratio, economic stability, political environment, and investor confidence.

Higher credit ratings mean lower default risk.

Currency Risk

Fluctuations in foreign exchange rates are also a risk for holders of sovereign bonds. If the value of the currency they invested in falls, then the value of their bond follows.

Interest Rate Risk

Changes in interest rates also affect sovereign bonds’ value. Higher interest rates lead to lower bond value in the secondary market as investors seek investments with higher yields.

Is it a good idea to invest in sovereign bonds?

Sovereign bonds can be a secure or risky investment depending on the country you invest in. Investing in sovereign bonds can help add balance to your investment portfolio since it has the potential to earn higher returns.

Given the variety of sovereign bonds, it’s important to understand the type of sovereign bond you’re investing in, and the risks associated with it, so you know how well they suit your investment strategy.

Ready to invest in sovereign bonds?

Now that you know what sovereign bonds are, how they work, how to buy or trade, and the risks they come with, you’re better equipped to decide whether they’re the right investment for you.

If you think this would fit into your investment portfolio, don’t hesitate to get in touch with us.