What happens if the government doesn’t have enough money to repay coupon payments or bond principles? What should an investor do in such a situation? Today, I’m looking at default risk and what happens if the government is unable to pay its obligations on the bond.
Default risk
Default risk refers to the inability of the issuer to make payments on their government bonds. These payments include coupon payments or the principal amount upon maturity. When the government, who is the issuer of the government bonds, is unable to pay its obligations in coupon payments or the principal amount, they are exposed to what is referred to as default risk.
Investors have to be aware of this default risk.
Credit rating agencies such as Moody’s, Standard & Poor’s, or Fitch normally allocate a credit rating to a creditor, and this also includes issuers of government bonds. These rating agencies also allocate ratings to governments that issue government bonds. Many governments across the world actually issue government bonds.
When you go to a credit rating agency’s website, such as Moody’s, you will be able to find a rating for your country in terms of how they have assessed the credit risk or default risk of your country. There are many factors that they consider, including the economic performance of the country, political stability, liquidity, and the current debt amount that the country owes, among others.
Credit rating agencies look at these factors to allocate a credit rating to a country. These agencies use different styles of credit rating to assign a credit rating. Investors should keep in mind that default risk exists, and they should research and consider a country’s credit rating before investing in government bonds
One style used for credit rating– is to allocate ratings using the letters of the alphabet. For example, Moody’s or Standards and Poor’s use the letters A, AA, or AAA to indicate high credit ratings, while lower ratings are indicated by the letters B, C, and D. If a country is assigned a AAA rating, it means that its credit rating is excellent. However, if a country is assigned a D rating, it means that its credit rating is poor and considered “junk.”
Eurobond holders need to be aware of a country’s credit rating.
Eurobond holders are investors who lend money to the government in a currency other than the local currency, such as the Zambian kwacha. If you are a Eurobond holder, you need to be aware of the country’s credit rating because it can affect your cost of borrowing. Foreign investors are typically the ones who invest in Eurobonds, and they normally look at a government’s credit rating before investing. In fact, many Eurobond holders use a government’s credit rating to inform their investment decisions, and it affects how much they can offer the government in the competitive bidding process.
Since Eurobond holders invest large amounts of money into the government, they are part of the competitive bidding process. The credit rating of a country can affect how much they are willing to offer the government, and a poor credit rating can increase the cost of borrowing. Therefore, it is important for Eurobond holders to consider a country’s credit rating or default risk when they are bidding for government bonds.
If you want to find out Zambia’s credit rating, you can visit any credit rating agency’s website, such as Moody’s, and look it up.
Has the government ever defaulted on its bond obligations?
Yes, in fact, on October 14th, 2020, Zambia made history by defaulting on its 2024 Eurobond by failing to pay the coupon payment on that bond. A few years ago, Zambia was also unable to pay the coupon payments as well as principles on their government bonds when they were highly in debt. So, it has happened in the past.
What happens when a government defaults on its bond payments?
What normally happens is that they will sit down with their investors and negotiate a repayment plan. Let me separate these investors between local and foreign investors who are normally referred to as Eurobonds. Currently, as I am speaking, Zambia has managed to agree on a restructuring plan with its Eurobond holders. Zambia is estimated to be owing at least 17 billion US dollars to its Eurobond holders, and recently with China coming on board, Zambia was able to agree on a restructuring plan for its Eurobonds. This means that the investors have now agreed to stretch their payment plans, making it easier for the government of Zambia to repay the principles and coupons on these bonds. It has become more flexible for the government of Zambia to handle these Eurobond holders in terms of their obligations on the bond.
Debt cancellation
Another thing the government is trying to achieve is to have their debts canceled. This is an interesting angle that I am keen to see where it is going to take us. Will foreign investors actually cancel their debt? When you are talking about Eurobond holders, you need to know that these are wealthy individuals abroad who are investing their money into the Zambian government for the development of Zambia. It is not free money; they are using their savings to earn a return from Zambia. Whether these investors are going to agree to cancel their debt is something that we are all looking out to see how it is going to turn out
The risk is much lower with local bondholders than with Euro bondholders. If the government is about to default on local bondholders, they will negotiate again and agree to a restructuring plan, possibly rolling over payments to future periods. The government will agree with local bondholders to roll over coupon payments as well as principal amounts.
Many people think that when the government doesn’t have enough resources, they can simply ask the Bank of Zambia or the central bank to print more money to meet their debt obligations. However, it’s important to note that it’s not that easy for the government to make a decision to print money because printing money results in inflation. This causes the prices of goods and services to go up, resulting in an adverse effect on the government’s citizenry. This is the last thing the government wants to achieve.
Zimbabwe is a good example of how printing money affects a country. When Zimbabwe decided to print money to pay for their debt obligations as well as for their government projects, inflation flew off the roof. This decision resulted in Zimbabwe’s currency losing its value. It’s been reported that in the 2000s, for a Zimbabwean to buy a loaf of bread, they had to carry a wheelbarrow full of Zimbabwean dollars.
Therefore, printing money to meet debt obligations is the last option the government looks at. Many people think it’s as easy as printing money, but it’s not as easy as it seems.
What happens when you know about all the risks that I’ve been talking about in this article as well as my previous two articles?
When you are assessing an investment, don’t just look at the good aspects, such as the returns you’re going to make on your investment. You also need to be aware of the risks that you are going to face. It’s more like taking medication; you know you’re going to feel better after drinking Panadol, but you also need to be aware of the effects Panadol is going to have on your body so that you are ready for them. When it comes to investing, it doesn’t matter whether it’s a Government Bond, property, or the stock market. You need to be aware of the benefits as well as the advantages or disadvantages of investing or taking a certain investment vehicle.
Interest rate, default and inflation risk
When you are making an investment in government bonds, consider these risks: Are there risks that you’re able to afford to take, or how can you minimize your exposure to these risks? This is your time now to do your research.
- You could consider investing in bonds of shorter-term durations to reduce your exposure to inflation as well as interest rate risk. You could consider staggering your investment such that you are investing just in two year bonds every once in a while. For example, you could invest ZMW50,000 in a two-year Bond this month. After two months, you could invest in another two-year bond with another ZMW50,000, and so on.
- Always look at diversifying your investment. It’s not a must that you should just invest in the bond. You could look at other investment vehicles, such as the stock market.
- You could also look at investing in property. I’ve done videos on that, and there are other YouTubers who are actually looking specifically at property investment. Take a look at those as well.
So, this is how you take into account your exposure to the risks of investing in government bonds.
