A sovereign bond is a debt instrument issued by a government or sovereign body. These bonds can be denominated in both foreign and domestic currencies in order to facilitate cross-border investment. Just like other bonds, these also promise to pay the buyer a certain amount of interest over a specific number of year along with the face value of the bond upon maturity.
In order to gather the finances required to facilitate large-scale projects, governments or sovereign bodies normally have two options:
1. Raise taxes
2. Issue a bond
Raising taxes is a rather unpopular decision in the eyes of the public, which involves a lengthy legal process in order to put it into force. Sovereign bonds are therefore the preferred method of financing as they are similar to taking loans from the market.
The yield of the sovereign bond is the interest rate that the sovereign entities pays to investors in the bond. If a country/government is considered volatile with unstable economies and high inflation rates, these entities will have to issue higher interest returns on their bonds compared to more stable ones to account for these uncertainties.
The yield of a sovereign bond is based on three primary factors:
1. Creditworthiness - The issuing government/sovereign’s perceived ability to repay their debts which can be secured through a rating agency.
2. Country Risk - External/internal factors such as political unrest and war may also hinder a country’s ability to pay off their debts.
3. Exchange Rates - In cases where bonds are issued in foreign currency, changes in the exchange rate may lead to increased pay out pressure on the issuing government.