World Bond Funds: Do You Know the Risks?June 29th, 2012 by David Waring
US debt only makes up 36% of the world market. By opening up your portfolio to include bonds from the other major economic powers of the world, there should be great investment possibilities. However these possibilities also come with complications.
What are World Bond Funds?
World Bond Funds are Bond Mutual Funds or Bond ETFs that invest at least 40% of their assets in bonds outside of the United States. Typically the majority of their investments are in developed economies such as Japan, Germany, Australia etc. This makes them different than emerging market bond funds which invest at least 65% of their assets in bonds from emerging markets.
Word Bond Fund Risks
When you invest in world bond funds there are 3 major areas of potential returns and losses:
- Credit Risk – The risk that the issuers of the bonds will default. While traditionally this risk tends to be associated with emerging market sovereign debt or corporate debt, sovereign countries in more developed areas can also default. Greece defaulted in 2011 and there is concern that Spain, Portugal or maybe even Italy might default. If perceptions of a bond’s credit risk changes for the negative then all else being equal the bond will fall in value. This works both ways however, as perceptions of a bond’s credit risk changes for the positive, a bond can also rise in value.
- Interest Rate Risk – If interest rates rise, overall bonds and particularly sovereign bonds lose value. With world bond investing, you are not focused on US interest rates but local interest rates. Local interest rates, which are driven by local inflation among other factors, may be rising and falling on different cycles than the US. If interest rates fall, then all else being equal a bond will rise in value.
- Currency Risk – If you are a US Investor investing in US Bonds, you don’t have this risk as the bonds are denominated in US dollars. However, when investing in the government debt of other countries, the debt is denominated in the local currency of that country. This exposes you to currency risk. Currencies can rise and fall in value against one another, sometimes dramatically. From May 2011 to May 2012 the value of 1 Euro in US Dollar terms moved from being worth $1.48 to $1.25. In other words, an American than invested in European bonds would be down 16% due to currency fluctuations, even if the bonds did not change in value. The impact of changes in the value of the currency the bond you are invested in is denominated, is often a large part of the profit or loss on the investment.
Actively managed funds that invest in world bonds, require the manager to make the right decisions about credit risk, interest rate risk, and currency risk. It’s much more complicated than investing in US Government bonds. This also makes world bond funds more volatile than many other types of bond funds. For example world bond funds are historically about twice as volatile as intermediate term bond funds.
So what is the investor to do? For our thoughts read our article “Should You Invest in World Bond Funds“.