The Political Risk Premium: What Is the Bond Market Pricing?

Global government bond yields have risen sharply. But they have not risen equally.

That distinction matters.

A common increase in yields can be explained by familiar global forces: monetary policy, inflation expectations, energy prices, sovereign issuance and changes in investors’ appetite for duration. But those forces cannot necessarily explain why the borrowing costs of individual governments diverge—sometimes substantially—even when they are exposed to much the same global financial environment.

That dispersion raises a more interesting question:

Once global financial conditions and conventional macroeconomic fundamentals are accounted for, how much of the remaining variation in sovereign borrowing costs can be explained by political and institutional risk?

At PRS, we are using more than four decades of International Country Risk Guide (ICRG) data to investigate that question.

The objective is not simply to demonstrate that “politics matters.” Investors already know that.

The more useful questions are: Which dimensions of political risk are markets pricing? How large is the associated premium? And when does a deterioration in political conditions become financially significant?

Separating the global shock from the country risk

The starting point is straightforward.

Suppose sovereign spreads are determined by three broad sets of factors.

The first consists of global financial conditions: benchmark interest rates, global risk aversion, liquidity and other common factors affecting virtually every sovereign borrower.

The second consists of domestic economic fundamentals: public debt, fiscal balances, inflation, economic growth, foreign-exchange conditions and external liquidity.

The third is harder to observe and quantify: political and institutional capacity.

A government may have a difficult fiscal position. But can it actually pass a budget designed to improve it?

Can a fragmented legislature sustain fiscal consolidation?

Can a government implement politically difficult reforms without losing its parliamentary majority?

Will social pressures constrain policy?

Do investors have confidence in the institutions responsible for implementing those decisions?

These are fundamentally different questions from measuring the debt-to-GDP ratio.

And they are precisely the kinds of questions the ICRG has measured systematically for more than four decades.

Testing the political-risk premium

Our experiment begins with a conventional sovereign-spread model.

In simplified form:\[ Spread_{i,t} = \alpha +\beta_1 GlobalRates_t +\beta_2 GlobalRisk_t +\beta_3 Fiscal_{i,t} +\beta_4 Inflation_{i,t} +\beta_5 Growth_{i,t} +\beta_6 FX_{i,t} +\epsilon_{i,t} \]

We then introduce political risk.

Rather than simply inserting an aggregate political-risk score into the equation, however, the experiment is designed as a sequence of nested models.

Model One measures the effect of global financial conditions.

Model Two adds country-specific macroeconomic and fiscal fundamentals.

And Model Four decomposes that rating into its individual political and institutional components.

Model Three introduces the aggregate ICRG Political Risk Rating.

That last step is particularly important.

ICRG does not treat political risk as a single phenomenon. Its framework distinguishes among Government Stability, Socioeconomic Conditions, Investment Profile, Internal Conflict, External Conflict, Corruption, Military in Politics, Religious Tensions, Law and Order, Ethnic Tensions, Democratic Accountability and Bureaucracy Quality.

That allows us to ask a considerably more useful question than whether political risk and sovereign spreads are correlated.

We can ask whether adding political information provides incremental explanatory power after the variables already used by fixed-income investors have been taken into account.

And, if it does, we can identify which dimensions of political risk appear to contain the most information.

France provides a live experiment

Current conditions in the French sovereign-bond market illustrate the question particularly well.

France and Germany operate within the same monetary union and are exposed to many of the same global and European financial forces.

Yet the spread between French OATs and German Bunds has widened substantially.

Some of that difference can potentially be explained by observable fiscal fundamentals. But fiscal arithmetic alone may not capture the entire problem.

Investors must also evaluate the political capacity to alter that arithmetic.

A fragmented legislature, difficulty passing fiscal measures, weak government cohesion or declining political support can affect the probability that an announced fiscal adjustment will actually occur.

The distinction is subtle but important.

Debt is an economic variable. The capacity to deal with debt is partly a political variable.

That creates a testable hypothesis.

If conventional macroeconomic variables imply one sovereign spread while the market consistently demands another, does incorporating measures of political and institutional risk help explain the difference?

That is what we intend to measure.

Emerging markets present the opposite puzzle

The current global bond selloff creates another interesting experiment.

Rising benchmark yields have imposed losses on emerging-market sovereign debt. But changes in underlying sovereign spreads have been much less uniform.

Some countries have experienced substantial deterioration. Others have proved surprisingly resilient.

This allows us to separate two very different sources of bond-market losses.

A sovereign bond can decline because the global risk-free rate has increased.

Or it can decline because investors require a larger country-specific risk premium.

Those aren’t the same thing.

For investors attempting to distinguish systemic market movements from changes in sovereign creditworthiness, identifying that difference is potentially valuable.

And again, political-risk data give us another variable with which to test it.

From historical relationship to live signal

There is a second stage to the experiment.

Suppose the historical analysis establishes that particular ICRG components contain statistically and economically meaningful information about sovereign spreads after conventional variables have been controlled for.

We can then turn the historical relationship around.

For an individual country, we can compare:

Observed sovereign spread

versus

Macro-model-implied spread

versus

Political-risk-adjusted implied spread.

That potentially produces something more useful than another country-risk ranking.

It produces a market signal.

For example:

FRANCE — SOVEREIGN RISK SIGNAL

Current OAT/Bund spread: X bp
Macro-implied spread: Y bp
Political-risk-adjusted spread: Z bp
Principal ICRG drivers: Government Stability | Socioeconomic Conditions | Democratic Accountability
Signal: Political/fiscal risk premium widening

The precise variables and results will, of course, be determined by the empirical work rather than assumed in advance.

That distinction matters.

We aren’t beginning with the conclusion that ICRG explains a particular market movement and then searching for evidence to support it.

We’re asking whether it does.

Why a long political-risk history matters?

Financial markets generate enormous quantities of data. Political risk presents a different problem.

It is relatively easy to construct a political-risk measure retrospectively after a crisis has occurred. It is considerably harder to construct one that existed before the outcome was known and that has been measured consistently across countries and through multiple political and economic cycles.

That is where the length of the ICRG series becomes important.

PRS has been measuring political, economic and financial risk for more than four decades, across more than 140 countries. The resulting database now contains more than eight million risk points.

That history spans sovereign-debt crises, emerging-market liberalization, the creation of the euro, the global financial crisis, the pandemic, wars, commodity shocks, inflationary episodes and repeated changes in monetary regimes.

It therefore allows a different kind of question to be asked:

Did the political-risk information available at the time contain information about subsequent financial-market outcomes?

That is a considerably harder test—and a considerably more useful one.

Beyond sovereign bonds

Sovereign debt is only the first application.

The same experimental structure can be applied across asset classes.

For currencies, we can ask whether deterioration in particular political-risk components is associated with abnormal depreciation after macroeconomic fundamentals are controlled for.

For equities, we can test whether changes in institutional and political conditions help explain relative market performance.

For foreign direct investment, we can examine whether changes in political and institutional risk precede changes in investment flows.

Similar tests can be constructed for sovereign CDS, corporate credit, inflation and sovereign-rating changes.

The underlying proposition remains the same:

First remove what conventional economic and financial variables already explain. Then ask whether political-risk information explains anything that remains.

From country-risk publication to investment data

This also reflects a broader change underway at PRS.

For decades, ICRG has provided investors, corporations, governments, international institutions and researchers with structured assessments of country risk.

Increasingly, however, institutional users do not simply want another report to read.

They want the underlying data.

They want to combine political-risk variables with market prices, macroeconomic data, proprietary models and increasingly their own AI and analytical systems.

The forthcoming PRS data platform and API are being designed around precisely that use case: allowing users to interrogate the historical ICRG dataset directly and integrate its components into their existing analytical workflows.

The sovereign-bond experiment is therefore more than an academic exercise.

It demonstrates what becomes possible when political risk is treated not simply as commentary, but as structured investment data.

What comes next?

We are now running the experiment.

The next step is to estimate the models across countries and through time, test the stability of the relationships, examine the individual ICRG components and determine whether political-risk information materially improves our ability to explain sovereign spreads.

We will publish what we find—including where the relationships are weak or nonexistent.

Because the important question isn’t whether political risk sounds important.

It is whether we can measure what markets are paying for it.