Global Sovereign Bonds

Global Sovereign Bonds

Subject: Economy

Section: External Sector

Context:

Global sovereign borrowing will reach $10.4 trillion in 2022, almost a third above the average before the COVID-19 pandemic, according to the S&P Global Ratings.

While 137 countries will borrow an equivalent of $10.4 trillion in 2022, an estimated 30% lower than 2020, the overall figure is one-third higher than average borrowing between 2016 and 2019,

Borrowing in the economies of emerging Europe, Middle East and Africa (EMEA) will raise $253 billion to the equivalent of $3.4 trillion by the end of the year. Egypt, which has recently sought IMF assistance, is set to overtake Turkey as the region’s largest issuer of sovereign debt, with $73 billion worth of bond sales.

Tightening monetary conditions will push up government funding costs and rise in corporate defaults

Concept:

Global Sovereign Bond

National governments issue debt securities known as sovereign bonds, which can be denominated in either local currency or global reserve currencies, like the U.S. dollar or euro. In addition to financing government spending programs, these bonds can be used to repay older debts that may be maturing or cover interest payments coming due.

Sovereign bond yields are the interest rate the governments pay on their debt. Like corporate bonds, these bond yields depend on the risk involved for the buyers. Unlike corporate bonds, these risks primarily include the exchange rate (if the bonds are priced in the local currency), economic uncertainties, and political risks that can lead to a possible default on the interest payments or principal.

Three major determinants of sovereign bond yields:

• Creditworthiness – Creditworthiness is the perceived ability of a country to repay its debts given its current situation. Often, investors rely on rating agencies to help determine a country’s creditworthiness based on growth rates and other factors.
• Country Risk – Sovereign risks are external factors that may arise and jeopardize a country’s ability to repay its debts. For instance, volatile politics could play a role in raising the risk of a default in some cases if an irresponsible leader takes office.
• Exchange Rate – Exchange rates have a substantial effect on sovereign bonds denominated in local currencies. Some countries have inflated their way out of debts by simply issuing more currency, making the debt less valuable.

Bond yield and Bond Price

As bond prices increase, bond yields fall. For example, assume an investor purchases a bond with a 10% annual coupon rate and a par value of Rs. 1,000. Each year, the bond pays 10%, or Rs. 100, in interest. Its annual yield is the interest divided by its Par value. As Rs. 100 divided by Rs. 1,000 is 10%, the bond’s nominal yield is 10%, the same as its coupon rate.

Eventually, the investor decides to sell the bond for Rs. 900. The new owner of the bond receives interest based on the face value of the bond, so he continues to receive Rs. 100 per year until the bond matures. However, because he only paid Rs. 900 for the bond, his rate of return is Rs. 100/ Rs. 900 or 11.1%. If he sells the bond for a lower price, its yield increases again. If he sells for a higher price, its yield falls.

Movements in yields depend on trends in interest rates, it can result in capital gains or losses for investors.

• A rise in bond yields in the market will bring the price of the bond down.
• A drop in bond yield would benefit the investor as the price of the bond will rise, generating capital gains.

Causes of rising bond yield:

All those factors which increase supply of bonds vis a vis demand. Thus, the prices of bonds fall:

1. Boom

Strong economic growth typically leads to increased aggregate demand, which results in increased inflation if it persists over time. During strong growth periods, there is competition for capital. As a result, investors have a plethora of options to generate high returns. In turn, Treasury yields must rise for Treasuries to find equilibrium between supply and demand. For example, if the economy is growing at five percent and stocks are yielding seven percent, few will buy Treasuries unless they are yielding more than stocks.

2. Inflation

When inflationary pressures emerge, Treasury yields move higher as fixed-income products become less desirable. Additionally, inflationary pressures typically force central banks to raise interest rates to shrink the money supply. In inflationary environments, investors are forced to reach for greater yield to compensate for diminished purchasing power in the future.

3. Monetary policy tightening 

When interest rates are low, bond prices increase and thus, yield falls because investors are seeking a better return and vice-versa.

4. State borrowing

It increases the supply of bonds greater than its demand thus, price falls and yield rises.

5. Net Capital Outflow or rise in net export 

Demand for bond declines relative to supply and thus bond price falls and yield rises.

Signals?

Bond yields are one of the metrics available for economists to judge the health of an economy, among others.