Why government credit is different

Three kinds of debt issuer

A corporate issuer borrows to finance working capital and fixed assets that are meant to earn a profit. Its debt is serviced from the cash its operations generate.

A sovereign issuer is a national government. It borrows to conduct fiscal policy and meet budget needs: infrastructure, health care, education and other public goods. It repays mainly from taxes and other government revenue such as fees, tariffs and, in some countries, the profits of state-owned enterprises.

A non-sovereign government issuer sits below the national level or beside it: regional and local governments, government agencies and similar quasi-government bodies. Their debt is backed either by their own power to levy local taxes or by the revenue of a specific public project.

Why the sovereign is usually the safest borrower at home

A national government can tax every company and household under its jurisdiction. No other domestic borrower has a claim on the whole economy like that, so the sovereign's bonds normally carry the lowest credit risk of any issuer in that country.

In the most advanced economies, sovereign debt is often treated as default-risk-free and serves as the benchmark that other bonds are priced against. Bonds of emerging and frontier market governments carry more default risk, and sovereign defaults are not unusual as countries move from emerging toward advanced status.

The core questions are the same as for any borrower: how stable and predictable are the issuer's cash flows, are they enough to cover interest and principal, and how heavily does the issuer rely on debt rather than other resources? What changes is the evidence: for a government, the 'cash flow' is the tax base and the policies that shape it.

Ability versus willingness to pay

Ability to pay is about resources: is there enough tax revenue and foreign currency to meet the payments? Willingness to pay is about choice: will the government actually honour the debt when paying is politically painful?

Willingness matters far more for sovereigns than for companies because of sovereign immunity. National laws limit investors' power to push a government into bankruptcy or to liquidate its assets to settle claims. Bondholders' legal recourse is restricted, and foreign creditors in particular may be unable to enforce their claims fully.

So sovereign distress rarely ends in a liquidation. With several lenders involved, and often multilateral lenders such as the International Monetary Fund (IMF), creditors usually agree to a restructuring: longer maturities, lower interest rates, or both, for a period, in the hope of recovering their money over time.

A restructuring can be called voluntary and still count as a default. If investors receive too little compensation for being paid later, or if holders who refuse the exchange end up subordinated to those who accept, analysts treat the deal as a default in substance.

A company that cannot pay faces a court that can sell its assets. A government that will not pay faces mainly reputational and market pressure. That is why the political side of sovereign analysis carries so much weight.

The analyst's toolkit

Sovereign creditworthiness is judged on a mix of qualitative and quantitative factors specific to the public sector. The qualitative factors describe institutions and policy choices; the quantitative factors use ratios built on GDP, government revenue and foreign-currency figures.

Notice the similar-sounding names. Fiscal flexibility and economic flexibility are qualitative; fiscal strength and economic growth and stability are their quantitative counterparts. External status (qualitative) pairs with external stability (quantitative).