A bond operates in much the same way as a bank loan or a mortgage, it shares many of the same principles; i.e. money is loaned from one party to another for a fixed period of time and at a specified rate of interest.
So, a bond is a form of debt between two or more parties. These parties can be individuals, companies, local authorities, governments etc.
Therefore, when a national government needs to raise money on the capital markets to fund its day-to-day expenditure, it does so using the same established fund raising process. This form of debt is know as a Sovereign bond.
The bonds are usually issued in the investors preferred currency (commonly: GBP, USD or EUR) to avoid exposure to foreign exchange losses on repayment.
Sovereign bonds are also known as government bonds or treasury stock. However, they are usually referred to as gilts or gilt-edged debt securities.
Whatever terminology is used, the principle is the same; the government has borrowed money and it needs to be repaid in accordance with the terms of the loan agreement.
How does a Sovereign bond work in practice?
Legally, a bond takes the form of a debt instrument: this is a legal document which sets out the terms and conditions of the bond:
- the names of the lender(s) and borrower;
- the amount to be borrowed;
- interest rate to be applied;
- repayment dates and
- the legal jurisdiction which governs the bond.
The latter point is exceptionally important as each country applies different rules around enforcing the terms of a bond.
For that reason, investors prefer bonds to be issued under English or New York law as it offers better legal protections to them in the event of a problem arising.
What’s the difference between Sovereign bonds and Sovereign debt?
Sometimes, the terms Sovereign bond and Sovereign debt are used inter-changeably. However, it should be noted that bonds are just one form of debt; it may be that the government has borrowed money in other ways.
For example, governments can take on loans from other countries or enter into separate borrowing arrangements with the world bank. Governments can also issue treasury bills etc so when these are all added together, they constitute Sovereign debt.
Sovereign debt is sometimes referred to as national debt or government debt.
What happens when a government defaults on its Sovereign bonds?
When a government fails to settle its debt (bond) obligations, it is known as a default. The terms of the bond agreement usually contain provisions for dealing with this situation.
Where a default can be explained as being a temporary cashflow problem (for example), then the government is typically given an agreed period of time (14 or 28 days) to ‘cure’ or fix the problem. The government needs to set out the steps they will take to resolve the issue.
However, a government defaulting on its debts is usually indicative of a much more serious underlying issue with the finances of that country. That can often mean the government is simply unable to pay and therefore measures need to be taken to restructure the bonds.
In practice, this restructuring means reaching a new repayment agreement with its creditors; for example, extending the repayment date and perhaps paying a higher rate of interest to compensate for the increased risk.
In the event that a government fails to address the default situation and reach agreement with its creditors, then it can very quickly find itself locked out of the capital markets. Therefore, the government will be unable to access any credit to enable it to meet its public expenditure requirements.
Ultimately, this leads to a so-called ‘government bailout’. This is where an external organisation such as the International Monetary Fund (IMF) or the European Central Bank (ECB) intervene to provide the money needed to continue funding governments’ spending obligations.
In effect, the IMF or ECB become lenders of last resort and they can impose very strict conditions around the terms of these ‘bailout’ loans.
For example, they could insist that governments need to raise additional revenue to meet the cost of the ‘bailout’ by increasing income tax rates or VAT. Or they could require the government to drastically cut back on proposed infrastructural projects (no new schools or hospitals to be built for ‘x’ number of years).
Other types of bonds
To learn more about other types of bonds available, please click here.
