Why Governments Issue Foreign Bonds

When a government needs money to fund its operations, it can raise cash by issuing debt in its own currency. And if a government encounters difficulty repaying the bonds upon their maturity dates, it can simply print more money.

While this solution has merit, on the downside, it will likely decrease the value of the local currency, which can ultimately harm investors. After all, if a bondholder earns 5% interest on a bond, but the currency’s value drops 10% due to inflation, that investor net loses money in real terms.

For this reason, countries may decide to issue debt in a foreign currency, thereby quelling investor fears of currency devaluation eroding their earnings.

Key Takeaways

• When governments need money to fund their operations, they may issue debt in their own currencies, but if they struggle to pay off the bonds, they can print more money. This can cause inflation, which ultimately erodes investors’ earnings potential.
• As an alternative to issuing debt in its own currency, a government may issue debt in a foreign currency to calm investor fears of currency devaluation eroding their earnings. 
• Issuing debt in a foreign currency exposes a nation to exchange rate risk because if their local currency drops in value, paying down international debt becomes costlier.
• To evaluate a foreign nation’s default risk, investors and analysts may evaluate a country’s debt-to-GDP ratios, economic growth prospects, political risks, and other factors. 

Double-Edged Sword

While issuing foreign debt may protect against inflation, borrowing in a foreign currency exposes governments to exchange rate risks, because if their local currencies drop in value, paying down international debt becomes considerably more expensive.

This challenge, which some economists refer to as “original sin,” came to a head in the late 1980s and early 1990s, when several developing economies experienced a weakening of their local currencies and consequently struggled to service their foreign-denominated debt.

During that era, most emerging countries pegged their currency to the U.S. dollar. Since then, many have transitioned to a floating exchange rate to help mitigate risk.

Default Risk

Government bonds issued in a foreign currency tend to draw high levels of scrutiny from investors seeking to evaluate the potential for a nation to default on its bonds, where a country would be unable to pay investors back.

After all, there are no international bankruptcy courts where creditors can recover assets, leaving them little recourse if a country defaults. Of course, there are compelling reasons for a country to make good on its obligations.

Chief among them: failure to pay bondholders can ruin its credit rating, making it difficult to borrow in the future. And if a nation’s own citizens hold much of the national debt, defaulting can render government leaders vulnerable at election time.

Important

After Argentina famously defaulted on its government debt beginning in 2001, it took several years for the nation to regain its financial footing.

Evaluating Default Risk

Telegraphing potential defaults is difficult, but not impossible. Investors frequently rely on debt-to-GDP ratios, which examine a country’s borrowing level relative to the size of its economy. But this metric doesn’t always correctly predict defaults.

For example, Mexico defaulted in the 1980s when its debt represented over 50% of GDP, while Japan has kept its financial commitments despite carrying a roughly 250% debt to GDP level.

Consequently, it’s prudent to take cues from credit rating agencies like Moody’s and Standard & Poor’s, who evaluate a multitude of factors when grading the debt of sovereign governments around the globe.

Case in point: in addition to looking at the country’s total debt burden, these agencies additionally assess economic growth prospects, political risks, and other metrics. Some economists also advise looking at a nation’s debt-to-exports ratio, because export sales provide a natural hedge against exchange rate risk.

What Are the Disadvantages of Foreign Bonds?

Investing in foreign bonds comes with many risks. Investors are exposed to exchange rate risk, political risk, economic risk, and credit risk of the nation as well as companies (if corporate bonds) in that nation. Investing in foreign countries that are more stable reduces these risks compared to investing in less stable countries or those with developing economies.

Can U.S. Citizens Buy Foreign Bonds?

Yes, U.S. citizens can invest in foreign bonds through their broker. Additionally, investors can gain access to foreign bonds via bond mutual funds or exchange-traded funds (ETFs). When investing in foreign bonds it’s important to consider tax implications, credit risk, exchange rate risk, and political risk.

What Is the Safest Government Bond in the World?

U.S. Treasuries are considered the safest government bond in the world due to the strong and reliable economy of the U.S. U.S. Treasuries are considered “risk-free” because there is no expectation that the U.S. will default on its bonds.

The Bottom Line

Governments issue debt to raise money to finance projects or fund their deficits. They do this by issuing bonds, either in the local currency or a foreign currency. Both come with their benefits and drawbacks.

Issuing local debt can lead to inflation and the erosion of purchasing power for the population. It can also reduce investment returns. Issuing debt in foreign currencies leaves governments vulnerable to exchange rate risk, which could potentially increase repayment costs.

Issuing debt in foreign currencies, however, could come with lower rates and access to international investors, as well as the government’s diversification of its own debt issuances.