An attractive way for fixed income investors to diversify their portfolio and gain foreign exchange exposure is to invest in sovereign debt. Sovereign debt is essentially a promise by a government to pay those who lend it money at a predetermined interest rate. The main difference between sovereign debt and government debt is that government debt is issued in the domestic currency whilst sovereign debt is issued in a foreign currency.

Fixed income investing is essentially the process of one person or entity making a loan to another person or entity. When an individual makes an investment in a government bond that individual is in fact making a loan to the government at the interest rate that is defined in the terms and conditions of the bond.

International investors tend to like to invest in currencies that they know and trust as a result they tend to invest in the US dollars and the pound sterling. As a result developed countries can issue sovereign debt in their own currencies, developing countries such as Jamaica are not that fortunate, for obvious reasons.

Typically developing countries have to issue sovereign debt at higher rates than developed countries to account for perceived additional risk, in terms of the stability of currency and stability if the government.

Now a new investor may ask why a country would want to pay back its debt in the first place, the answer is to avoid damage to the country’s reputation. Many developing countries rely on foreign investment in order to create jobs (and votes) as well as growth. Defaulting on sovereign debt will cause these investments to decline as investors reassess the risk of investing in that particular country.

That is not to say however that a country will not default. There are a number of reasons why a country will default. One reason may be currency crisis within the country, that is the rapid loss of value of the domestic currency making it increasingly expensive to convert to the foreign currency, another reason may be challenging economic circumstances for example when a countries GDP is largely dependent on commodity exports and there is a decline in demand for those exports.

Another reason is a change of government, in countries where there is a radical shift in government policy due to change in leadership, investors may be at risk as the new government may view the countries debts as problems brought about by the previous administration.

Countries that have defaulted in recent times include North Korea (1987), Russia (1998) and Argentina (2002). Fortunately there are signals that a country will soon default and should a fixed income investor be paying sufficient attention, they should be able to get back their funds before such an event occurs. Typically fixed income manager spend most of their time analyzing the data on such countries in order to avoid being caught in such an event.

Bob Russell is the assistant vice president, structured finance at Mayberry Investments Limited. He can be contacted at bob.russell@mayberryinv.com,