So with all the newspapers
and magazines going gaga over Sovereign bonds and the ability of India to raise
capital through these (Some are saying to the tune of $8billion), the word has
suddenly become the new hot and sexy word in the finance world.
So, what is a sovereign
bond? And how will it help in stalling the fall of rupee and how it will help the economy in general? Are there
any risks involved? What are those risks? How will it be mitigated? Does Greece
and Spain, with whom, the word Sovereign has so closely been mentioned all
these months when they failed, have done something which India should be wary
of?
These and other questions
are cropping up and rightly so. These need to be addressed. So,
what is a sovereign bond? And what is sovereign? Simply speaking, sovereign is government.
Although the literal meaning does mean a ruler or king, for our purpose, govt. will suffice. And a bond is a paper issued by anybody which says that
that the person (Or the organization) which issued the bond owes some amount of
money, generally printed on the paper. Think of NSC papers or Kisan Vikas
Patras! They are bonds! Simple no?
For that matter, say you
want to open up a company and need money for that. You decide to raise money
through public, but do not want to offer an IPO(Initial Public Offerings!). So,
what you will do is you will announce to your friends that you want some money
and you are willing to offer a fixed amount of interest on that. They give you
the money. How would you assure them that they will receive the interest and
the amount they lent you? Simple, you will offer them a legal paper which will
state the amount borrowed, interest amount (maybe) and a promise to pay that
back! So, in effect you have decided to issue bonds to raise money! Which is
nothing but a promise made so that you can borrow money and would pay later! Or
in economic terms, these papers called bonds are in effect a way to borrow
money. Or what economists call as Debt Instruments! Easy Peasy!
Now, as you can guess, what
will happen if your company fails? Or you run away with all the money without
actually investing all that money anywhere? Or you die? Or you are notoriously
known for not paying back and nobody is actually interested in lending you
money? Or the idea of your company is
very shaky and even if you are a saint, the lenders doubt your company will do
good enough to pay you back?
All these are risks associated
when bonds are issued. Now, inflate the stakes, as we always do, and think of
a country needing money and that too dollars? What will it do? It will try to
issue bonds in dollars (which means bonds which are denominated in dollars and
can be bought in dollars only and payable also, in dollars!), hoping to strengthen its economy with all that money
and then pay back with all the more
earned (And hopefully, strengthen own currency so that dollar cost can be lowered.
Think of buying dollars at 60 a pieces,
making money on that and in the process, bringing the dollar down to 50! So , a
country will earn 10 Rs per dollar without moving a muscle! Awesome! )
So, now, let’s get a bit
more involved. A sovereign bond is a debt security issued by a national
government within a given country and denominated in a foreign currency. The
foreign currency used will most likely be a hard currency, and may represent
significantly more risk to the bondholder. The risk is, say if dollar weakens(In
our case , Rupee Strengthens, so somebody who has bought the dollars by selling
a rupee will actually lose out if, say interest earned is 10 Rs and dollar has weakened
by more than that! Poor guy! ) And the debt so obtained is called sovereign debt!
Again, elementary stuff!
A US bond looks something
like the one given below:
Now, a few things to note
are that the denomination that is printed on the bond is the amount that the
person buying the bond will be getting at the maturity( i.e, after the time for
which it was taken,has elapsed) . Then what is the profit that the bond holder
will be getting? The funda here is that bonds are issued at what we call generally
a discount . So, a 10% discount bond will mean that a bond of $ 1000
denomination will actually be available at $900, a 10% discount. These discounted
bonds are also called as zero yield bond!
The other thing to talk and
know about is related to the risk that we talked about. Remember you running
away with the money? In case of
sovereign bonds, ratings are allocated to countries, as shown below:
Countries with AAA ratings
are those with least risk and hence will have to pay lower discount or lower
interest rates since they are considered safe .In case of India, the figure
above means we have to offer higher interest rates to attract investors,
because of BBB- ratings. Generally, lower the ratings, the more riskier it is
and hence higher rates. Compare that with the money lenders who lend at higher
rates because no documentation is involved and the fact that the borrower could actually run
with the money. If you have an idea about the Sub prime market, banks lends to
those customers who have a bad credit history at higher rates to compensate for
higher risks involved!
Now, in case of India, latest data from the RBI shows forex reserves
fell to a three-year low of $280.17 billion in the week ended July 5. A
sovereign bond issue would infuse more dollars into the domestic financial
system, the liquid dollar available will increase and have a bearing on the
rupee. And hopefully, more dollars in the economy will strengthen rupee and
also shore up economics into higher growth mode.
Risks are that India will
come under sovereign pressure, though it will be a good thing if the pressure
is taken positively and the money is used for manufacturing and real economic growth rather than funding some fancy Gandhi plans, which will only lead to increased
risk of default! We have issued these bonds twice in past, once when we were
broke in 1991 and another in 1998. We need to make sure we raise money by
planning better rather than as a panic reaction, which is what even 2013 bond
issues will be, if there is any!
Of course, there are countries
which have defaulted on Sovereign bonds, such as Russia Rubel default in 1998
which sent the stock markets and bond market crashing and the current defaults
by Greece and other EU countries, which are facing very high sovereign default
risks (If in local currency, you can print money, but then hyperinflation lurks
just around the corner and what to do if they are in dollars!) But then again,
another article for that!
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