Sovereign Bonds: Here's everything you should know

The government is now planning to borrow 10-15 percent of the total borrowing offshore, costing at least Rs 71,000 crore.

Creditworthiness: The issuing countries’ perceived ability to repay their debts.

Country risk: External/internal factors such as unrest and wars tend to jeopardise a country’s ability to pay.

Exchange rates: In cases where bonds are issued in foreign currency, fluctuations in exchange rate may lead to increased pressure.

Further, creditworthiness additionally depends on other factors. For instance: lower inflation, greater foreign exchange reserves, lower original stock of debt (original sin) and lower exposure of the banking sector to government bonds all contribute towards higher creditworthiness. Typically, a country's sovereign credit ratings cover most of these factors.

Broadly, the borrowing cost depends on the sovereign rating that a country commands. Ratings from ‘AAA’ to ‘BBB-’ are classified as investment grade while ratings from ‘BB+’ to ‘D’ are classified as speculative grade. Currently, India commands a ‘BBB-’ investment grade rating according to S&P. Russia and Indonesia are countries with sovereign ratings similar to India's. Even though India’s credit rating is the same as Russia's, the spread in case of India could be lower. This is because investors could attach a scarcity premium to Indian bonds owing to the fact that this would be India's first issuance as well as the scarcity of the supply of Indian bonds.

According to economists from HDFC bank, the Indian sovereign bond could be priced in line with some of the better rated countries like Indonesia and the Philippines. The spread for a 10-year bond could be around 100 bps.

The 12-month onshore forwards premium currently stands at 4.5 percent. If Indian sovereign bonds are priced at 3.2 percent, the total funding costs can be estimated to be 7.7 percent, including the one-year hedge costs. This would be more than the current domestic borrowing cost of 6.5 percent from the government securities market. Thus, assuming the coupon rate of 3.2 percent and the 12-month forward premium of 4.5 percent, it is unlikely that the government will cover its full exposure every year. At these rates, the government shall be able to cover around 75 percent of its exposure to break even with the domestic cost of borrowing.

Alternatively, the government could practise a conditional event-based hedging practice. Hedging on a one-year-basis would still leave the currency risk open to some degree (the forward premium would fluctuate). Hence, conditional hedging could be a preferred strategy to deal with the currency risks.

The risk of default is particularly high in case of a high stock of external debt -- in excess of 50 percent of the GDP. India seems to be safe on this count. Additionally, the risk of default due to illiquidity is especially high if short-term debt exceeds 130 percent of reserves. For India, this ratio currently stands at 26.3 percent.

Unlike corporate debt restructuring, there is no mechanism for national governments to declare bankruptcy, which complicates the restructuring of sovereign debts. The restructuring of sovereign debt (with bailouts from IMF) generally takes the form of some conditionalites (such as austerity) on the fiscal plans of the government.