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Sovereign vs corporate bonds

Sunday, October 01, 2017

A bond is a debt instrument whereby an entity can raise capital to finance their operations by attracting investors to participate. Simply put, it is a loan to the entity (referred to as the issuer) and will have certain contractual features such as principal amount (face value), rate of interest payable (coupon rate), coupon dates (dates on which interest is payable) and a maturity date.

Some bonds may have additional features such as a call date and security. The former gives the issuer the right to call back (repay) the bonds from the bondholder (investor) after the date specified while the latter is assets that have been pledged to secure the debt in the event the issuer is unable to repay the bond holder. Many of these bonds are traded on international exchanges.

Governments and corporate institutions worldwide borrow/raise funds through the issuance of bonds. This has been a popular vehicle through which they have been able to raise funds to finance government expenditures and company operations, but how are they different?

A sovereign bond is debt issued by a national government and can be denominated in the company's own currency or alternatively in a foreign currency. Countries with strong currencies such as the United States of America have the luxury of issuing such bonds as their economy is strong and their currency is accepted worldwide.

Countries with weak currencies on the other hand pose a greater risk to bondholders and therefore, to eliminate the currency risk, will issue their bonds in a foreign currency such as US dollars. Jamaica is a typical example of one such country and has gone the route of issuing their bonds in US dollars. Whilst this eliminates the currency risk, it certainly does not eliminate the country's credit risk.

A corporate bond, on the other hand, is debt issued by a corporation and is one of the prime sources of capital for businesses in addition to bank loans and equity financing through the issuance of shares.

Similar to governments, a company has to have a good reputation and the potential to generate consistent income from its operations in order to appeal to investors for its bond offerings. In some instances, corporations have to offer much more, such as providing collateral to secure the bonds to make them more attractive to the market.

In comparing both classes of bonds we start with the credit risk. Both are evaluated by their ability to repay, and a measure of this is the relative credit rating each enjoys by international credit rating agencies such as Standard and Poor's, Moody's and Fitch.

The rating agencies will use a country's fiscal accounts or a corporation's financials in addition to other data regarding future earnings and political risk to determine that rating. It is this rating that will determine the cost of raising the funds in the market to the issuer.

Sovereigns are normally considered less risky than corporates, but this is dependent on the country of issue and whether the market is international or domestic.

As an example, Jamaica currently has a B+ rating by Standard and Poor's, but their bonds are trading at a premium which brings the effective yield to investors willing to buy, equivalent to that of a bond of a higher rating and in the investment grade category. This is partly due to the confidence that locals in Jamaica and the diaspora have in the country's ability to honour its obligations.

Their relatively lower risk will be applicable in comparison to their local corporate investments, but not by external investors.

We have seen countries that have defaulted on their bonds due to political risk, and Argentina has been one such country in recent times. Currently Venezuela is approaching that critical point. Corporations operating in such countries are also subjected to similar risks and as such will prejudice their ability to raise funds and the subsequent cost of funds on the capital market.

We mentioned previously the currency risk for sovereign bonds, and it should be borne in mind that this would be applicable to corporations operating in less developed countries. They too will issue in a currency other than their local currency to eliminate the risk to investors.

They are both exposed to the risk that any deterioration in their fiscal/financials could lead to a devaluation of their local currency, thereby placing more strain domestically on them to service their obligation.

In closing, both classes of bonds are similar in a number of respects, but local investors will view their sovereign bond a little differently from an international investor. Local investors will have a better feel for their own government's attitude and ability to honour their obligations as opposed to an overseas investor.

For investors who are not savvy in doing their own research, it is recommended that they seek advice from a qualified investment adviser.

 

Ian Watson is vice-president, Sales & Marketing at Sterling Asset Management Ltd. Sterling provides financial and advisory services to the corporate, individual and institutional investor. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, please e-mail us at: info@sterlingasset.net.jm or visit our website at www.sterling.com.jm