Sovereign Bond Yield: What It Is, How It Works

What Is Sovereign Bond Yield?

Sovereign bond yield is the interest rate paid to the buyer of a sovereign bond; a debt security issued by a national government, or sovereign entity, in order to raise capital for its funding needs.

Understanding Sovereign Bond Yield

Sovereign bond yield is the rate of interest at which a national government can borrow. Sovereign bonds are sold by governments to investors to raise money for government spending, such as financing war efforts.

Sovereign bonds, like other bonds, yield the full face value at maturity. Sovereign bonds are the number one way that governments satisfy budgeting needs. Since many sovereign bonds are considered risk-free, such as U.S. Treasury bonds (T-bonds), they do not have credit risk built into their valuation, and therefore they yield a lower interest rate than riskier bonds.

The spread between sovereign bond yields and highly-rated corporate bond yields is often used as a measure of the risk premium placed on corporations. It is important to consider all of these factors together when considering an investment in sovereign or corporate bonds.

Technically, sovereign bonds are considered risk-free because they are based on the currency of the issuing government, and the government can always issue more currency to pay the bond on maturity; however, this is not the case in reality.

Factors that affect the yield of a specific sovereign bond include the creditworthiness of the issuing government, such as economic strength and political stability, and the value of the issuing currency on the currency exchange market.

Sovereign Bond Ratings

The creditworthiness of sovereign bonds is typically based on the perceived financial stability of the issuing government and its ability to repay debts. International credit rating agencies often rate the creditworthiness of sovereign bonds—notably Moody's, Standard & Poor's (S&P), and Fitch. These ratings are based on factors that include:

• Gross domestic product (GDP) growth
• The government's history of defaulting
• Per capita income in the nation
• The rate of inflation
• The government's external debts
• Economic development within the nation

When a government is experiencing political instability, or suffering from external factors that contribute to instability, there is a risk that the government could default on its debts. During the sovereign debt crises that have occurred in the past, markets reacted by pricing in a credit premium and this increased the cost of new borrowing for these governments. Recent examples include the European debt crisis and crises in Russia and Argentina.

Even without credit risk, sovereign bond yields are influenced by currency exchange rate risk and local interest rates. This is especially true if governments borrow in a foreign currency, such as a country in South America borrowing in dollars because the devaluation of their domestic currency could make it harder to repay the debt. Borrowing in another currency is typically something done by countries with currencies that are not very strong on their own.

The Bottom Line

Sovereign bonds are issued by countries to raise money for their expenses. The yield on a sovereign bond will depend on the bond's rating, which corresponds to its safety/riskiness. A high-rated (safe) bond will have a lower yield whereas a low-rated (riskier) bond will have a higher yield. Riskier bonds must pay a higher return in order to entice investors for taking on the increased risk of default by the issuer.