Is the Bond Market Pricing the Right Sovereign Risk?

When a sovereign bond sells off, the obvious conclusion is that the country has become riskier.

But that conclusion can be wrong.

A dollar-denominated Nigerian government bond, for example, can fall sharply even when absolutely nothing has changed in Nigeria.

If U.S. Treasury yields rise, the yield required on Nigerian dollar debt will normally rise as well. A long-duration Nigerian bond can consequently experience a substantial price decline even if Nigeria’s sovereign spread—and investors’ assessment of Nigerian risk—has barely changed.

That is an interest-rate and duration event.

Now imagine Treasury yields remain unchanged while Nigeria’s sovereign spread widens by 200 basis points.

That is a very different signal.

Investors are demanding substantially more compensation specifically for holding Nigerian risk.

Distinguishing between the two is essential.

Academic research using International Country Risk Guide (ICRG) data has been doing precisely this for years.

Erb, Harvey and Viskanta used ICRG ratings to estimate sovereign spreads while controlling for differences in bond duration. Bekaert, Harvey, Lundblad and Siegel subsequently used ICRG political-risk data to separate the political-risk component of sovereign spreads from global conditions, economic factors and liquidity. IMF researchers have similarly used ICRG political, economic and financial risk indicators to distinguish global forces from country-specific determinants of sovereign borrowing costs.

The practical lesson is simple:

Yield is not the same thing as sovereign risk.

Today’s markets provide several good examples.

France is particularly interesting because the relevant signal is not simply the French government bond yield. It is the spread investors demand over comparable German Bunds.

If French and German yields rise together, the movement may largely reflect common European interest-rate conditions.

If French yields rise while German yields do not—or rise considerably more—the widening spread contains information about France itself.

Fiscal sustainability matters, but so does political capacity. A government may understand what fiscal adjustment is required while lacking the parliamentary support or political cohesion necessary to implement it.

Political risk can therefore become fiscal risk, and fiscal risk can become a sovereign risk premium.

Japan illustrates the opposite problem.

Long-term Japanese government bond yields can rise substantially because inflation and interest rates are normalizing after decades of extraordinarily low rates. Long-duration Japanese bonds may suffer substantial price declines as a result.

But a large price decline does not necessarily imply an equally large deterioration in Japanese sovereign creditworthiness.

So what should investors watch?

Not simply yields.

Watch the benchmark rate.

Watch the sovereign spread.

Understand the bond’s duration.

And compare those market signals with changes in the country’s underlying political, economic and financial risk fundamentals.

The really interesting cases occur when those signals disagree.

If a country’s sovereign spread suddenly widens while its underlying risk indicators remain relatively stable, the market may be charging an unusually large risk premium—or anticipating deterioration that has not yet appeared in the fundamentals.

If political and financial conditions deteriorate while the sovereign spread remains unusually tight, investors may instead be underpricing the risk.

Neither result proves that the market is wrong.

But both tell us where to look.

With more than four decades of ICRG political, economic and financial risk data across more than 140 countries, we can compare changes in underlying country risk with changes in the price markets assign to that risk.

And that leads to a more useful question than simply asking whether sovereign yields are rising:

Is the bond market pricing the right sovereign risk?