The Hidden Risks Of International Bond InvestingJanuary 6th, 2012 by David Waring
Anyone buying a bond bears certain financial risks, including the possibility that inflation will rise and erode the “real” value of the bond’s principal. Another important consideration is the possibility of default by the entity issuing the bond, which may not be able to pay interest or principal due to economic circumstances.
Investors buying foreign bonds have an additional important factor to consider:
The exchange rate between the US Dollar and the currency in which the foreign bonds are denominated may fluctuate. The investor loses out if the currency in which the foreign bonds are denominated loses value against the US Dollar, while the investor is holding the foreign bond. This can cancel out some or all of the benefit the investor receives for the bonds interest and principal payments.
The Euro has lost significant value against the dollar since in the second half of 2011. The Euro lost over 10% of its value (falling from 1.45 to 1.30) during the six month period. Had you held a bond denominated in Euros (for example a French government bond), the value of the bond would be down over 10% in US dollars from currency exposure alone. This is outside of any gain or loss due to the bond itself.
As almost all European debt lost value during this time due the snowballing European financial crisis, you would have been hit with double whammy: a poor investment return due to market conditions and a currency loss.
The reverse can also happen.
Over the last few years, Americans that invested in Canadian debt benefited from the increasing value of the the Canadian dollar, and a strong Canadian economy, which spurred demand for Canadian government debt.
Investors considering the purchase of foreign bonds may often look first at government securities, often known as sovereign bonds. There is plenty of information on sovereign bonds from commentators and credit rating agencies enabling investors to research the investment thoroughly before they buy. As with any other type of bond a higher yield on sovereign debt reflects higher risk. Where government bonds are seen as carrying higher risk they must offer a higher interest rate, current examples being Ireland, Spain and Italy.
Diversifying the risk
Generally it is a good idea to diversify the risk by investing in a number of different foreign bonds. One quite easy way to make a diversified investment in foreign fixed income securities is to invest in a foreign bond exchange traded fund (ETF). ETFs cover various types of investment and geographical regions, and some ETFs cover foreign fixed income securities.
Here are a list of ETFs that give investors exposure to foreign bonds:
CAD – Pimco Canada Bond Index Fund
AUD – Australia Bond Index Fund
EMB – iShares JP Morgan USD Emerging Markets Bond ETF
BWZ – SPDR Barclays Capital Short-Term International Treasury Bond ET
BUND – Pimco Germany Bond Index Fund
IBND – Barclays Capital International Corporate Bond ETF
JGBL – PowerShares DB Japanese Govt Bond Futures ETN