FI 5 Fixed-Income Markets for Government Issuers

Public sector issuers complete the picture of the major fixed-income sectors. A national, or sovereign, government issuer stands apart from every private borrower because of one legal power: the ability to set up and sustain the nation’s public goods and services, together with the right to tax economic activity inside its borders. Because it can draw on tax cash flows generated across the whole economy, rather than the operating cash flows and asset sales that a company relies on, a national government carries the lowest default risk among issuers in its own currency and is usually the largest bond issuer in its domestic market.

Beyond taxes, a government has other sources of repayment, including tariffs, usage fees, and cash flows from state-owned enterprises. How much of the economy a government occupies, and how those activities split between the national level, quasi-government agencies, and regional or local bodies, varies widely from country to country.

Two balance sheets: economic and financial

It helps to picture a government the way an analyst pictures a firm, through a balance sheet of sources and uses of funding. The narrower view is the financial balance sheet, which records the borrowed capital, that is, the outstanding debt. The wider view is the economic balance sheet, which also captures expected future claims (the tax revenues a government expects to collect) and promised future obligations (the expenditures it has committed to). Because those forward-looking items are exactly what determine a government’s long-run capacity to service debt, the economic balance sheet is more relevant for a public issuer than for a private one.

The financial balance sheet captures only the debt items; the economic balance sheet adds the expected future claims and obligations.

Accounting for the public sector is not uniform. Where private issuers report under generally accepted accounting principles (GAAP), government standards differ widely and are frequently kept on a cash basis rather than an accrual basis. A cash basis tends to leave out things a company would accrue: the wear and tear on durable public assets such as federal highways, and the quiet buildup of unfunded obligations such as promised government pensions. The economic balance sheet, by design, brings those future claims and obligations back into view.

A central distinction among national issuers is whether they are developed market or emerging market sovereigns. The difference shows up in the stability of the economy behind the debt, the currency the debt is written in, and the ease of access across maturities.

A developed market (DM) sovereign rests on a strong, stable, and well-diversified economy. Its budget is built mostly from consistent, recurring outlays funded by broad-based individual and business taxes, which makes fiscal policy stable and transparent. Its bonds are denominated in a major currency that foreign governments are content to hold in reserve. Together these features let a DM sovereign issue what is often called default-risk-free debt with essentially unconstrained market access across the whole maturity spectrum.

An emerging market (EM) sovereign typically shows higher growth but a less stable and less diversified economy that swings more sharply over the cycle. It often leans on one or a few dominant industries, such as commodities, and features more state-owned or state-controlled enterprises. Budget priorities may include large investments in economic and social infrastructure that outrun current tax cash flows, which is where external or supranational funding enters. EM debt is frequently written in a restricted domestic currency, one with limited convertibility because of illiquidity, and such currency restrictions can deter foreign investment and shorten the maturities available in domestic currency.

Domestic debt versus external debt

For an EM sovereign it matters greatly whether debt is domestic or external. Domestic debt is issued in the domestic currency and is held mostly by domestic banks, institutions, and other local investors. External debt is money owed to foreign creditors: borrowings from supranational financial organizations plus foreign-currency issuance bought by foreign private investors. Earlier modules noted examples of EM Eurobond issuance, for instance the quasi-government PT Indonesia Infrastructure Finance bond in US dollars and Romania’s bond in euros.

A developed market investor who buys an EM sovereign’s foreign-currency bond does not bear the same direct currency risk as a holder of that sovereign’s domestic-currency debt. The exposure is indirect but real: repayment depends on the issuer earning enough hard currency, from its cross-border flows of capital, goods, and services, to cover the foreign currency coupons and principal. If that revenue falls short, the bonds can default even though they are written in the investor’s own currency.

Two different policy levers shape a government’s debt. Fiscal policy sets the level of sovereign debt: central government spending, covering both budget requirements and debt service, is weighed against tax receipts, fees, and revenue from state enterprises. A budget deficit raises the need to borrow; a surplus reduces it. Forecasting future debt levels means allowing not only for policy changes but also for how sensitive spending and revenue are to growth and inflation.

Debt management policy sets the composition of that debt: the split between short and long term, and other features. Sovereign debt issues fall into three broad groups.

1. Short-term paper maturing within 1 to 12 months, commonly known as Treasury bills. As a rule these carry no coupon and are sold below par at a discount.
2. Medium- and longer-dated securities, the notes and bonds. The typical form is a domestic-currency instrument paying a fixed coupon, though governments also sell floating-rate, inflation-linked, and foreign-currency versions.
3. Securities a government guarantees without issuing them itself, which effectively function as sovereign debt. The best-known case is conforming mortgage-backed securities, above all in the United States.

Ricardian equivalence and the maturity question

In the corporate reading, the Modigliani-Miller theorem held that, under strict assumptions, a firm’s choice of capital structure does not affect the present value of its expected cash flows. Sovereign debt has an analogous result, Ricardian equivalence: under similarly simplified assumptions, a government’s pick of debt maturity leaves the present value of its future tax receipts unchanged. Taxpayers, on this view, treat government debt as merely deferred taxation, so the government should be indifferent between taxing today and borrowing at any maturity. The assumptions are demanding:

1. Households even out their spending over time, setting money aside now for the heavier taxes they foresee.
2. They reason correctly that a tax cut today implies a tax rise tomorrow.
3. Markets work frictionlessly, with no transaction costs, so households can borrow and lend at will.
4. Households care about their heirs, handing any tax savings down through the generations.

Relaxing those assumptions is where practical debt management begins. Very short government paper offers holders strong liquidity and safety, and it often works as a stand-in for bank deposits. Under normal conditions these very short instruments carry a liquidity premium, meaning their yields sit lower than they otherwise would because of that liquidity benefit. Short-term debt is issued at regular intervals in standard maturities, yet governments keep the leeway to scale each auction up or down to handle unpredictable cash flows, whether near-term tax collections or sudden funding gaps.

Why not fund entirely short-term

Taken literally, Ricardian equivalence suggests a government should borrow at the shortest possible maturity to minimize cost and avoid any term premium on longer rates. In practice that is unwise. Heavy reliance on short-term funding creates rollover risk, the uncertainty of refinancing cost, which makes budget costs and therefore tax rates more variable. Because taxpayers cannot perfectly smooth consumption and do not form perfect cross-generational expectations, this fiscal instability breeds uncertainty about future taxes and threatens steady economic growth. Governments therefore spread debt across maturities and issue at regular, predictable intervals, accepting somewhat higher cost in exchange for stability.

Fiscal policies differ sharply across the 38 OECD member countries, yet their maturity structures have varied far less. By year-end 2021 the OECD’s weighted average maturity sat a little more than a year above its 2007 reading. Around 85% of outstanding sovereign debt was long term, little changed from 2007, and yearly issuance divided roughly in half across the two buckets (bills return to market more often, since they mature sooner). That span covered two major recessions and heavy sovereign issuance.

The benefits of enough long-term issuance

Maintaining a liquid supply of longer-term government securities across maturities delivers several system-wide benefits:

1. A risk-free benchmark for every maturity. Sovereign yields let analysts strip out a private issuer’s credit risk premium, so debt policy often mandates regular benchmark issuance across maturities to improve market efficiency and transparency.
2. Interest-rate risk management. Dealers and asset managers lean on medium- and long-dated government bonds, and the derivatives tied to them, to handle interest rate exposure apart from credit exposure.
3. Preferred collateral. Longer-dated government bonds serve as the collateral of choice in repurchase (repo) and derivative deals, thanks to their liquidity and safety. Repos let a seller finance a position and give the buyer a short-term collateralized investment with little liquidity or default risk.
4. Monetary policy and reserves. Central banks use government securities to conduct monetary policy, through outright purchases and sales and repo contracts, and foreign participants hold much of their currency reserves as liquid government bonds.

Debt policy is not static. Shifts in the amount of debt, the size of deficits, and the gap between short- and long-term rates can all change it. When the United States was running a budget surplus, it stopped issuing 30-year Treasury bonds in October 2001 over cost concerns, a move that stunned the market and produced the largest one-day price swing in years on supply worries; the 10-year note became the de facto long-term benchmark in the interim. Issuance of the 30-year bond came back in February 2006 to fund deficits that tax cuts and wartime outlays had opened up.

Corporate debt issuance is opportunistic and run by investment bank underwriters acting for the issuer. Sovereign issuance works differently: it normally runs through a public auction that the national Treasury or finance ministry conducts, using standard procedures that give a transparent price discovery process and broad distribution.

Competitive and non-competitive bids

Once an auction is announced, investors submit bids of two kinds. A competitive bidder names an acceptable price and a quantity; if the price set at auction ends up above that bid, the competitive bidder is allotted nothing. A non-competitive bidder simply agrees to accept whatever price the auction determines and always receives securities.

Single-price and multiple-price auctions

In both auction formats the issuer ranks bids by price, taking them from highest to lowest until the desired amount is filled. The formats then diverge. In a single-price auction every winning bidder pays the same price and receives the same coupon, whatever they bid. In a multiple-price auction, bidders end up paying different prices for the same issue. A single-price process can lower the cost of funds and broaden distribution among investors; a multiple-price process can narrow the distribution of large bids, because those investors must accept bonds at their own bid price.

A single-price auction moves through four phases:

1. Announcement. The debt management office sets out how much and what type of paper is on offer, when the auction and issue fall, when the bonds mature, and the bidding window.
2. Bidding. Dealers, institutional investors, and individuals submit competitive or non-competitive bids.
3. Allocation. All non-competitive bids are accepted. Competitive bids are ranked starting from the lowest yield (highest price). The highest yield needed to fill the offering, counting up from the bottom, is the cut-off, or stop yield. Every security is sold at that single stop yield; competitive bidders who bid a higher yield (lower price) receive nothing. Results are published.
4. Delivery. The bonds are handed to the non-competitive bidders and the successful competitive ones, against payment.

Primary dealers and secondary trading

Sovereign issuers work with financial intermediaries too, but in a distinct form. Governments designate a set of intermediaries as primary dealers, required to take part in every auction with competitive prices. Primary dealers also frequently act as the central bank’s counterparty in open market operations and help foreign central banks and other indirect bidders buy and sell government debt. In certain markets investors can bid directly, for example via TreasuryDirect in the United States or the UK Debt Management Office.

After issuance, sovereign debt trades much like private sector debt, mainly over the counter (OTC) through broker/dealers, though a few markets, such as Australia, use an exchange. In each market the sovereign is usually the largest borrower, and its securities are the most liquid fixed-income instruments available. The most recently issued securities, known as on-the-run, are used for benchmark yield analysis because they trade more actively than earlier off-the-run securities. Given that liquidity, some on-the-run trading takes place electronically on centralized private marketplaces.

Non-economic investors and reserve currencies

A notable difference from corporate trading is the presence of large investors in sovereign debt who pursue non-economic objectives. In US Treasuries, for example, the Federal Reserve holds them to conduct monetary policy; foreign governments keep them as US dollar reserves; state and local authorities, hemmed in by rules on what they may own, are steered toward Treasuries; and banks and insurers either must hold Treasuries or are encouraged to for regulatory reasons. This demand lowers sovereign borrowing costs relative to the private sector, and the effect is strongest for issuers of a reserve currency, one that global central banks hold in size and that is widely used in international trade and finance.

Not all public sector debt is sovereign. The level and type of non-sovereign funding vary widely by country, depending on whether particular public goods and services get delivered and paid for nationally, regionally, or locally. Some non-sovereign issuers resemble sovereigns in that they can levy taxes within their jurisdiction; others depend on national budget allocations or user fees, with or without a national or local government standing behind them as a backup source of repayment. In every case, access to funding across maturities hinges on how predictable and stable those repayment sources are, which is what drives the issuer’s credit quality.

Government agencies

A government agency is a quasi-government body that borrows to pay for particular public goods or services the state has chosen to back, whether under national or local law. The Airport Authority of Hong Kong (AAHK) is the statutory agency that operates and develops Hong Kong International Airport; it issues a mix of short- and long-term debt for the airport’s working capital and capital investment needs, repaid mainly from airport operating cash flows, with sovereign backing as a secondary source. In the United States, the Government National Mortgage Association (Ginnie Mae, distinct from Fannie Mae and Freddie Mac) securitizes and guarantees certain mortgage loans to promote home ownership; it issues callable agency debt with maturities matched to its guaranteed mortgages, repaid mainly from guaranty fees on the mortgages it backs and related cash flows, again with sovereign backing as a secondary source.

An important nuance: although each of these agencies can usually borrow at a yield-to-maturity close to its sovereign guarantor’s, neither enjoys the full liquidity premium that true sovereign debt commands.

Local and regional authorities: GO and revenue bonds

Regional and local governments issue two broad types of bond. A general obligation (GO) bond funds general public goods and services within the issuer’s limited jurisdiction and is repaid from local tax cash flows; it is unsecured, backed by the government’s taxing power. The Province of Ontario’s green bond, summarized below, is a GO bond repaid from provincial tax revenue, with proceeds ring-fenced for eligible green projects. A revenue bond, by contrast, finances a specific project or piece of infrastructure (a road, bridge, or tunnel) and is repaid from that project’s own revenue stream, such as tolls or fees. Revenue bonds are usually longer dated, with maturities set to match the expected life of the project cash flows.

Supranational organizations

Supranational organizations, among them the World Bank, the International Monetary Fund (IMF), and the Asian Development Bank (ADB), are set up and funded by sovereign governments serving as member states around a common goal: deepening economic cooperation and development, advancing trade, or lending to emerging economies to support sustainable growth. Member states usually share decision-making and provide both implicit and explicit financial support, which gives these issuers the highest credit quality in this group and strong access to capital markets across maturities.

At times supranationals and sovereigns team up to create quasi-government agencies able to borrow more cheaply than an emerging market sovereign could on its own. PT Indonesia Infrastructure Finance (IIF), introduced earlier as a US dollar Eurobond issuer, draws its market access from indirect Indonesian government ownership and strong support from a consortium of public sector bodies, including the ADB, the World Bank Group’s International Finance Corporation (IFC), and the German development bank KfW (Kreditanstalt fuer Wiederaufbau).

Supranationals target investors in major currencies through global bond markets. In the note summarized below, the ADB borrowed in Indonesian rupiah but pays interest and principal in US dollars, with the dollar sums set from the rupiah amounts at the spot USD/IDR rate two business days ahead of each payment, so investors still bear currency risk.