Investing In Sovereign Bonds

Investing in sovereign credit has been, and has become again, a dicey affair. Countries' resources have been taxed, in view of the financial unwind that has overtaken much of Europe and the United States, and there's been outright mismanagement and political discord. Arrangements to keep various nations' financial systems breathing has brought about a great deal of borrowing and not always sufficient resources to repay.

All of this begs the question as to whether investment in sovereign obligations is worthwhile. Indeed, history is rife with examples of governmental financial mismanagement, with many a nation the victim (or perpetrator) of serial defaults over time.

Inherent Risk
To gain a sense of the challenges of investing in sovereign bonds, it helps to understand that embedded in them are several types of risk.

• Interest Rate Risk
  Bond prices and interest rates are inversely correlated. While this type of risk is common to most types of fixed income, changes in rates affect government bond prices, making their sale and purchase more precarious.
  
  
• Political Risk
  Multifaceted, this risk requires of the analyst an understanding of a nation's political process. How stable is the incumbent government? How influential is the opposition? Regime change could directly impact a government's willingness and/or ability to make good on its obligations. Do race and religion have a role in the political process? What is the strength of trade unions and other organized forces? To what extent are key industries nationalized or privatized?
  
  
• Economic Risk
  How well do a nation's current account earnings pay for its external debt and debt service? What are acceptable limits that allow it to meet its obligations while not sacrificing crucial services to its people (e.g. infrastructure, trash collection, electricity)? What is the level of foreign borrowing relative to current income? Who are its creditors? Does the nation have abundant natural resources and does it use them effectively? How well defined is its fiscal policy? What are the current and historical rates of unemployment and inflation, and why? What are the sources of growth and why?
  
  
• Foreign Exchange Risk
  Depending upon the currency in which the investor "keeps score" (reports returns), he or she could be subject to greater volatility and losses if the home currency is strong, relative to the foreign one, and the exposure is unhedged. The strength or weakness of a nation's currency is a function of its competitiveness, business climate, export diversification, source of foreign exchange, the degree of governmental control on it and protectionism.
  
  
• Default/Restructuring Risk
  This is no different than the risk that an individual might fail to pay his or her bills on time. Default risk embodies all of the foregoing considerations which, if they point to a lack in funds flowing to the coffers, may cause a nation to run afoul of its creditors, which often leads to a ratings downgrade and lack of confidence in that nation's ability to effectively manage its systemic risks. Sovereign creditors may not have recourse to a bankruptcy code to enforce repayment. Investors have used the credit default swap (CDS) to speculate, as well as hedge off the viability of a sovereign's obligations to its creditors, sometimes holding this form of insurance policy with no insurable interest.

Sovereign Debt or Sovereign Death?
Given the multiple risks inherent in government paper, a proper analysis needs to be forward looking. If officialdom is willing and ready to implement tough reforms to pare back debt through restructuring and/or fiscal means, then there could be hope. Too strict a diet, however, and the consequences could be harsh, if not altogether devastating. Consider the August 2011 fracas over the increase to the United States' debt ceiling, due to partisan bickering to the 11th hour, and a resultant credit downgrade from two ratings agencies. In this instance, U.S. paper "prevailed" in spite of itself, due to the dollar's globally recognized reserve status. However, the country's staggering debt load can be sustained for only so long.

The value of individual eurozone countries' debt is a function of its members' fiscal policy. Indeed, owing to its near death experience with hyperinflation in the 1920s, Germany has become the model of fiscal and monetary probity and the country is alternatively looked to or loathed by its fellow EU members in the ongoing mess in the European Monetary Union (EMU). By contrast, the peripheral eurozone nations of Greece, Portugal, Ireland, Spain and Italy have been accorded yields of varying punitive degree by the markets, as a function of their individual fiscal circumstances.

Are Sovereign Bonds Worth Investing In?
Governments typically do not go out of business, but leadership often passes through a revolving door. Extensive and ongoing study of the risks earlier listed in this piece is essential. Individual and institutional investors must clearly define and articulate their objectives for purchase and understand the key contractual components of the debt: who holds it and how easy or difficult it is to trade or, if necessary, restructure, when holding it becomes untenable. Investors should focus on countries where growth (or its potential) is higher, aggregate indebtedness is lower, financial flexibility exists, the ability and willingness to repay is evident, public accounts are transparent and asset protection exists.

The Bottom Line
Finance has proven to be cyclical. There is progress followed by regression, succeeded by advancement yet again. Learning the lessons of history is a sine qua non. One thing is certain: the cycles do repeat themselves, providing ample fodder for study.