What are government bonds
U.S. government issues bonds with a promise of periodic interest payments (coupon payments) along with repayment of the face value of the bond upon maturity. These are issued with the complete backing of the issuing government and are therefore considered to be low-risk investments albeit with low yields. It is a kind of debt issued by the government and sold to investors. Bonds are sold by the government to support government spending on infrastructure, education, health, etc.
Bonds are also issued by large corporate houses. Normally corporate bonds promise higher rates of interest as opposed to government bonds. Rates are determined by the crisis susceptibility, stability, and perceived performance trajectory of the issuing entity. Generally speaking, most governments across the globe are perceived to be stable by and large – that is why government bond yields are less but they come with higher security.
A benchmark bond is a bond used as a standard of measure in reference to which performances of other bonds can be measured globally. These are rated most highly and act as a security and other bonds react to their prices.
Who else is in the bond map
There are basically two types of bonds; namely, government and corporate. However, each of these further has sub-categories. In addition, it must not be forgotten that other than the US, other countries also float bonds in the bond market.
U.S. Treasuries (bonds issued by the U.S. government) are considered worldwide to be the most secure and risk-free bonds, possible to get for an investor. This is because it has the absolute backing of the government since the U.S. Treasuries act as a benchmark. Bonds floated by other countries may come with higher degree of risks. Countries that are not currently in a good economic shape and are undergoing a slump in growth would promise bonds with high-interest rates to attract investors. Examples are what happened in Turkey, Egypt, and Greece. After the world financial crisis/recession in 2008, these countries issued bonds with returns as high as 38% in order to attract investments because of the low trust in their governments at that point in time. Also, high rates will cause a fall in bond value due to the opportunity cost of holding such bonds when better returns could be achieved elsewhere. Currency risk also factors in. This means, if you buy a bond that does pay you in your currency then the difference in the exchange rate may see your investment value drop.
The game of trust
You are safest when investing with the U.S. government. Why? It is all a game of trust. The trust factor with the U.S. government is sky-high globally. That is the reason why the interest rates here are lower than other equities and corporate bonds. The 10-year Treasury bond functions as a benchmark and acts as a guide for interest rates on lending products.
Government-backed bonds in emerging markets potentially carry varied risks depending on the issuing country, its politics, its central bank and banking system solvency, etc. Due to these reasons, countries are forced to devalue their currency. A prime example is the Asian Financial Crisis – 1997 that resulted in many Asian currencies to devalue. The impact was felt across the globe in a big way; so much so that Russia defaulted on its debt.
Investors use sovereign credit ratings as a measure to analyze the risk factor of a particular country’s bonds. Standard & Poor’s, Moody’s and Fitch are reputed global credit rating organizations. S&P provides BBB- or higher rating to countries considered to be investment grade. However, for countries it considers as “junk” grade or countries that are considered to be speculative; the organization offers a BB+ or lower ratings.
It is important for you to check credit ratings of a country and also factor in its GDP growth trajectory, inflation rates, unemployment rate, central bank interest rates, and sociopolitical stability before investing. Good GDP growth shows how efficient the economy of that country is – for example, a GDP of 8%-10% is considered good and very good respectively. High GDP translates into high infrastructural demands and likewise provides a chain reaction of growth in all sectors. High inflation rates mean a fall in your bond value. Coupon rates lower than the inflation rate results in a real loss of money. The high unemployment rate indicates that the economy is not able to provide a livelihood to a good chunk of its citizens. This means that the government may lack the ability to pay back your debts due to its weak demands. Central bank rates significantly affect bond yields. Monetary policy with falling interest rate will make bond prices rise resulting in a fall in bond yields. If all parameters of analysis fall within the realm of a good macroeconomic environment, only then it is advisable to make an investment, else you should avoid it.
Sociopolitical risks also impact bonds. Countries like Argentina still maintain high country risk. Argentina’s risk is the third highest in emerging countries if we include Turkey. In 2018, Argentina’s country risk increased 130% mainly due to the lack of prudent monetary policy, loss of foreign-exchange reserves, constant devaluation, abuse of financing of public spending by printing more currency by its central bank resulting in increased inflation and high-interest rates. Countries with high debt to GDP but having prudent economic policies are the better-rated countries.
Conclusion: Pros and cons of foreign bond investment
- Allows diversification during periods of decline in the American market
- Requires professionals – most foreign bonds do not allow direct purchase by an individual
- Foreign market exposure and opportunity to earn from attractive foreign economies
- Liquid market to resell
- Professional management comes with administrative cost
- Bonds are safer but may not offer returns like foreign stocks
- Adding more by way diversification makes tax calculations complicated
- Bond risk due to various factors are always there with high-risk investments
- Currency risk due to inflation and devaluation
- Income from foreign bonds is taxable in the U.S.