Sovereign Bonds and Phorex Money!

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!