Sovereign Debt is debt issued by a government as a means to borrow money. This is typically tied to deficit spending when the revenues from taxes do not cover all the expenses.
This can also be called government debt, public debt, and national debt. They are listed on the balance sheet of the treasury as liabilities.
Governments will issue bonds, notes, and bills. These are sold into the market, using by the central banks through their primary dealers. The dealers will purchase them both for their own accounts as well as on behalf of their clients. Obviously, since these are global banks, the purchasers of the debt is a mixture of domestic and foreign entities.
Sovereign Debt And The Reserve Currency
The United States, since the end of World War 2, saw itself has having the global reserve currency. Throughout the world, the US dollar is recognized as the safest of all the fiat currencies. This has translated into the USD being the unit of account for the pricing of most international trade. Commodities such as gold and oil are all priced in this.
A trade deficit is also run by the United States. This means it buys more on the international market than it sells. From a transaction standpoint, we see the currency flowing outwards, around the world. This is one of the requirements to serving in this role. If the currency does not flow throughout the world, global trade is hindered.
As countries take in more USD due to the trade deficit, US Treasuries (the sovereign debt of the US) are purchased. These can be thought of as future dollars since the bond market is the most liquid in the world. It is a safe way for foreign entities to park their USD while also getting a return.
Countries, or specifically central banks, know that holding US Treasuries means it can gain access to USD when needed. Since almost half the global debt is denominated in USD, corporations that float it require USD to make payments. Here is where the banking system is tasked with ensure enough is available.
Treasuries held by the central bank serve this purpose. This is one of the reasons why the United States never has an issue with selling its debt.
Eurodollar System
Sovereign debt has been a major player, historically, in the Eurodollar System. International banks and financial institutions has long used that as funding in the short term lending markets. After the Great Financial Crisis, where mortgage backed securities (MBS) lost their value, sovereign debt was the only collateral that institutions were willing to accept at a reasonable rate.
The negative interest rate policy (NIRP) that stared with the ECB and spread to many other central banks caused a major crimp in this market. As countries started to blow up their bond markets, the appeal of these assets for collateral purposes waned. This severely restricted the market due to the constraint on bank balance sheets.
Once again, we saw US Treasuries elevated as money. In this arena, any asset that has liquidity and can be traded fulfills the need for money. Since the market for US Treasuries outpaces all others, this satisfied the need. At the same time, the Federal Reserve did not break below the zero interest rate policy (ZIRP) it enacted a number of times.
Default Risks
When it comes to risk, sovereign debt is considered to carry the lowest risk. Unlike commercial paper and corporate bonds, governments can always use taxation as a means to cover the cost of servicing the debt. Here is where the full faith and credit of the government enters.
This actually means that governments can place debt repayment ahead of all else. It can use taxation and the ceasing of other payments to ensure the continued servicing of the debt.
Of course, not all sovereign debt is the same and the benchmark for credit risk is the 10-Year US Treasury bond.
There are risks associated with this form of debt. Over the years we can find a number of examples of how governments defaulted on their debt. These tend not to be major nations although that is not eliminated from the equation either.
One challenge is that, unlike corporate debt, when default occurs, bond holders find it difficult to go after the assets of a country. Therefore, the resource is rather limited compared to other forms of debt.
Some of the attributes of sovereign debt apply to other forms of government debt such as municipal bonds.
Another factor in sovereign debt is the currency it is issued. When debt is issued in the currency of a nation, it can carry less risk of default since money can be created to cover the debt. However, the flip side of this is that foreign investors take on an added risk due to the currency exposure. Exchange rate risk is something that international investors are always looking at.