All the recent talk about auctions and bonds is confusing to anyone not in the know. Thankfully, we’ve created a handy guide, detailing what you need to know about sovereign bond auctions.
What is a Sovereign Bond?
A sovereign bond is issued by a national government that promises to pay a set amount on a certain date, as well as interest payments. Bonds are debt investments where an investor loans an amount of money to a country for a period of time. The bonds are usually carried out in the government’s home currency, but they can be issued in a foreign currency.
The first ever government bond was issued by England in 1693 to pay for its wars with France. After that date European governments started issuing perpetual bonds which meant that they had no expiry date, Again these where mostly used to fund wars and other government spending. Perpetual bonds were phased out in the 20th century, these days governments only issue limited duration bonds.
In a sovereign bond auction, embers of the public and banks bid for bonds via auctions. People and organisations are willing to bid for government debt as they see it as a risk free investment. After all a government can raise taxes and other sources of income to ensure the debt is paid off.
However, because the cost of issuance for a publicly auctioned bond can be cost prohibitive for a smaller loan, it is also common for smaller bonds to avoid the underwriting and auction process through the use of a private placement bond. In the case of a private placement bond, the bond is held by the lender and does not enter the large bond market
The Dangers of Sovereign Bonds
Normally Sovereign bonds are regarded as risk free due to the various ways they can raise funds. Countries have defaulted on their debt with terrible economic consequences. In 1998 Russia defaulted on its debts and faced national bankruptcy. More recently Greece defaulted on its bonds creating the major cause of the Euro crisis. It was unable to sell enough bonds to pay its debts due to investors regarding them as high risk. Being a member of the single currency didn’t help matters.
The main risk to bond deals is inflation. If the inflation rate is higher than the government or investor expects it will make the bond more expensive for the buyer. This has the chance of reducing the appeal of an investor taking the debt on in the first place.
Most governments issue inflation indexed bonds that protect investors from the impacts of inflation. It does so by increasing the interest rate given to the investor as inflation increases.