Question

What is sovereign debt? What specific characteristic of sovereign debt constitutes the greatest risk to a sovereign issuer?

Answer 1

Sovereign debt - also referred to as government debt, public debt, and national debt - is a central government's debt. Sovereign debt is issued by the national government in a foreign currency in order to finance the issuing country's growth and development. The stability of the issuing government can be provided by the country's sovereign credit ratings which help investors weigh risks when assessing sovereign debt investments.

There are several types of negative credit events that investors should be aware of, up to and including a debt default. A debt default occurs when a borrower (in this case, a government) can't (or won't) pay back its debt. In this case, bondholders no longer receive their scheduled interest payments, nor do they receive their principal on maturity. Bondholders will often negotiate with a government to receive some value for their bonds, but this is usually cents on the dollar, and rarely approaches 100% of the initial investment.

A debt restructuring occurs when a government anticipates difficulty in repaying its debt as planned, and therefore comes to an agreement with bondholders in order to renegotiate the terms of the bonds. These changes can include a lower rate of interest, longer term to maturity or reduced principal amount. These restructurings are done to benefit the bond issuer and are almost always negative for bondholders (except to the degree that they prevent a default.)

A final negative development for bondholders is inflation. Because it is not technically a default or other credit event, issuers that can't (or won't) pay back their scheduled debts sometimes prefer to inflate their way out of the problem. From a bondholder's perspective though, high inflation results in principal and interest payments that carry less value (from a purchasing power perspective) than they initially planned for.