Bond issuers come from national governments, local governments, quasi-governmental institutions, supranational institutions, and companies. Each has a different default risk. For example, government default bonds are considered less risky than corporate bonds. Therefore, corporate bonds generally have a lower credit rating than sovereign bonds.
Which bonds should we choose? It depends on our tolerance level for risk. For example, government bonds can be an option when we have a low tolerance level. However, corporate bonds with a low credit rating may be a good alternative if we pursue higher returns.
Why do we buy bonds? Bonds are fixed-income securities. They are alternatives to assets such as stocks, real estate, or alternative investments. They offer us regular income, i.e., coupons, and we get back the principal on maturity. For example, when we buy corporate bonds, we lend money to the company. So, regularly, perhaps quarterly or semiannually, we receive coupon payments. And, at maturity, we will receive the principal.
Why do issuers issue bonds?
There are several reasons to issue bonds. To be sure, issuing bonds is a way to raise money for several purposes. For example, the government issues bonds to finance the budget deficit. Government revenues do not adequately cover its expenditures, leading to a deficit. To cover the shortfall, the government took out a loan. And issuing bonds is the most common way to cover the deficit.
Then, the company raises money by issuing corporate bonds. It becomes an alternative to issuing shares or taking bank loans. Unlike stocks, bonds represent obligations for which the company must pay coupons periodically and, at maturity, redeem the principal. Companies may issue bonds to finance investments such as building factories or purchasing production machinery. Or, they issue them to refinance maturing debt – taking advantage of low-interest rates to replace high-interest bonds with cheaper ones.
Who is the bond issuer?
There are several ways to classify bonds. For example, we classify them based on their creditworthiness as assigned by credit rating agencies. They include investment-grade and non-investment-grade bonds.
Or we categorize bonds based on currency denominations such as local currency bonds and global bonds denominated in foreign currencies. Or, we categorize them based on who the issuer is.
And by issuer, we classify bonds into:
- Sovereign bonds by the national government.
- Non-sovereign or local government bonds by governments at levels below national government administrations such as federal, provincial, and municipal governments.
- Supranational bonds by supranational institutions such as the World Bank and the International Monetary Fund (IMF).
- Quasi-government bonds by quasi-government institutions such as Fannie Mae in the United States.
- Corporate bonds by companies, both financial and non-financial companies.
The term for bonds issued by national governments is sovereign bonds. Sometimes, we also refer to them as government bonds or sovereign debts.
However, the terms bond and debt are slightly different. Bonds generally only cover those with longer maturities. In contrast, debt securities include short-term (bills), medium-term (notes), and long-term (bonds).
Reasons for national governments to issue bonds.
National governments issue bonds to cover expenditures when tax revenues are insufficient. In other words, they run a budget deficit. And they issue bonds to cover the deficit.
The government may increase the deficit – and therefore, issue bonds – when pursuing an expansionary fiscal policy in which the government increases spending and cuts taxes. Or, the government is building infrastructure which requires significant funding, making tax revenues insufficient to cover expenditures.
Sovereign bond currency
National governments may issue sovereign bonds in local currency or in foreign currencies. However, foreign currency-denominated bonds usually have lower credit ratings than local ones. That’s because bonds denominated in foreign currencies are considered riskier because they contain translation risk.
While it can print local currency to redeem local currency bonds (regardless of its effect on inflation), the government does not do so to redeem foreign currency bonds. Instead, the government relies on foreign currency reserves (which are limited) to repay foreign currency bonds. Indeed, the government can print money and exchange it for foreign currencies; however, it can lead to depreciation and disrupt macroeconomic stability.
Sovereign bond credit rating
Government bonds usually have a higher credit rating than other bonds, such as corporate bonds. Therefore, sovereign bonds are considered less risky than corporate bonds and, for this reason, serve as a benchmark for corporate bonds. However, sometimes, rating agencies assign corporate bond ratings higher than sovereign ratings.
Furthermore, sovereign bond ratings vary between countries. Bonds issued by developing country governments are naturally riskier – and therefore, lower-rated – than bonds issued by developed countries. Developed countries with the highest ratings (AAA) from the S&P are Singapore, Australia, Canada, Germany, Norway, Sweden, Luxembourg, the Netherlands, and Switzerland as of October 10, 2022. Meanwhile, the United States, United Kingdom, and France rated AA +, AA, and AA. Meanwhile, Indonesia received a BBB rating from S&P.
Local governments issue non-sovereign bonds to finance projects in their local areas, such as roads, airports, ports, schools, and infrastructure improvements. They may be federal, provincial, and municipal governments.
We may know municipal bonds (municipal bonds). Yes, that is an example of a non-sovereign bond.
Local governments repay bonds through local taxes under their jurisdiction. Or they source it from the cash flows generated by the projects they finance. Usually, local bond issuance also has full support from the national government.
Trends in non-sovereign bonds vary between countries. For example, some countries may not delegate authority to local governments and concentrate budgeting under the national government. Or the municipal bond market is underdeveloped due to regulatory issues. Thus, local governments are not authorized or challenged to issue bonds.
However, in some countries, such as the United States, the local government bond market is increasing. For example, on November 7, 2019, outstanding municipal bonds reached $3.7 trillion. That amount jumped from $361 billion in 1981.
Supranational organizations refer to global entities without being based in a specific country. They have members in many countries. The World Bank and the International Monetary Fund are examples of supranational organizations. The European Investment Bank is another example.
Supranational organizations issue bonds to fund their operations and projects. They then pay for the coupon payments through operating income. Like sovereign bonds, they usually have high ratings. In addition, they are issued in large amounts, so the market is also liquid.
Take the World Bank as an example. The agency has issued bonds since 1947 and is rated AAA by major rating agencies. And as of June 30, 2022, the institution’s total borrowings have reached $256.9 billion. In FY2022, the agency raised $40.8 billion of medium and long-term debt. Debt securities issued include sustainable development bonds, green bonds, non-core currency bonds, structured notes, and callable bonds.
Quasi-government institutions perform various functions for national governments but are not government entities. They issue bonds to fund specific financing needs. For example, Fannie Mae and Freddie Mac in the United States provide mortgage financing. Both are designed for investors to own.
Quasi-government bonds may be guaranteed by the government. Therefore, they usually receive a higher credit rating than similar unsecured bonds.
However, unlike sovereign or local government bonds, quasi-government bonds are not backed by a direct taxation authority. Thus, quasi-government institutions rely on recorded cash flows – or from projects financed – to service bonds.
Corporate bonds come from companies. They may be financial companies such as banks and finance companies. Or they are non-financial companies such as mining companies and manufacturing companies.
Companies issue bonds for several purposes, for example, to finance capital investments such as building a new factory or buying production machinery. Or they use the funds obtained for working capital purposes.
In addition, several companies also issue bonds to refinance maturing bonds. Or, they take advantage of the lower interest rate environment to replace expensive bonds with cheaper ones.
Issuing bonds is an alternative to raising funds other than issuing shares. Some companies may only issue stocks or bonds. However, others may issue both stocks and bonds at the same time. Thus, their shares are listed on the stock exchange, and their bonds are traded on the bond market.
Unlike stocks, bonds increase a company’s leverage because it is a liability. Therefore, companies must continue paying coupons and principal, even when not generating revenue. The higher the leverage, the higher the risk of default. Higher leverage indicates debt burden relative to the resulting cash inflows.
Higher leverage limits a company’s capacity to borrow. They may find it challenging to borrow more because of the higher default risk. And if they could, investors would demand high-interest rates to compensate for the risk.
Corporate bonds are usually considered riskier than government bonds. Corporate income is considered more uncertain than tax revenue by the government. Therefore, they generally have lower ratings, except for certain cases. In addition, they offer higher returns because they are riskier.
What to read next
- Bonds: Types, Features, Risk, Pros and Cons to Investing In It
- Complete Bond Features. What You Need To Know.
- Bond Issuers: Who Are They?