Risk assessment of government bonds

At least one generation of students learned that there was a so-called "safe interest rate" at which market participants could invest money without any risk. The financial and economic crisis and the crisis of the Euro Monetary Union have shaken this image. But how is the default risk of (large and economically developed) states determined in the first place?

How great is the risk of sovereign default?

There is no clear answer to this question. It goes without saying that the default risk of sovereign bonds is related to the ratio between the total existing debt of a state and its economic performance. This is why debt levels are so often published as a ratio to gross domestic product. However, this alone does not provide a satisfactory answer with regard to default risks on government bonds.

Japan, for example, has the world's highest government debt at 245% of GDP and was well ahead of Greece in this respect even before the outbreak of the financial crisis. Unlike the Hellenes, however, Japan did not need any aid measures. In the run-up to the financial crisis, the Greek economy had developed much more positively than Japan's economy, which was plagued by deflation. Looking at government debt and GDP alone is therefore not sufficient to assess the risk.

External balance

On the other hand, a major difference can be identified at another point: While Japan traditionally has a current account surplus, Greek imports exceeded the country's exports over a long period of time. A negative trade balance does not necessarily lead to higher government debt, but it does necessarily lead to higher debt for the economy as a whole. Greece, for example, has borrowed abroad through its national banking sector. Similar developments could be observed in Spain and Ireland in the course of the euro crisis.

Empirically, if an economy as a whole is highly indebted, there is a high risk of liabilities being transferred from the banking sector to the public sector: the debts of banks are taken over by the government as part of support measures, which causes government debt to rise sharply in a particularly unstable market environment. When these developments occur, investors can only react to a limited extent, because by that time the market value of the government bonds of the country concerned has already fallen significantly.

Characteristics of sound public finances

States are not purely economic institutions. Therefore, political power relations and developments also play a significant role in the effective default risk of government bonds. The USA, for example, is indebted to the tune of more than 100 per cent of its GDP in terms of public sector liabilities and has been running current account deficits since the 1970s.

Nevertheless, a national bankruptcy (not to be confused with a purely politically caused short-term insolvency) is almost impossible. The US can theoretically print unlimited amounts of money through its central bank and thus meet its obligations. If economically and militarily less strongly positioned states were to proceed in this way, a drastic exchange rate loss would be the consequence - international creditors would lose even if all bonds were formally serviced.

When assessing the risk of government bonds, private investors in swap ultimately have no choice but not to lose sight of overriding economic and political developments. The hallmarks of public solidity are the lowest possible stock and new debt as well as an external balance or current account surpluses. The further away a state is from these goals, the greater the risk of losses due to defaults or inflation.