A wide range of factors influence the performance of your bond funds, but the impact of the changing value of the U.S. dollar is underappreciated and frequently misunderstood.
When a fund manager buys a foreign security, he or she will typically buy it in the “local market,” or the market where the security is actually issued. That means the manager must buy the security in the local currency, which requires the exchange of U.S. dollars into that currency.
The currency exchange market is extremely active, which means that the value of the dollar is always shifting relative to the value of overseas currencies. The result is that a change in the value of the relationship between the dollar and the currency in which the security is purchased can have a meaningful impact on the value of the investment. The most important thing to remember is this:
A strong dollar will have a negative impact on the performance of international bond funds (since the value of the foreign currencies is falling).
A weak dollar will have a positive impact on performance (since the value of the foreign currencies is rising).
Let’s look at an example. Say a manager buys a million dollars worth of bonds denominated in British pounds and holds on to the investment for six months. During that time, the value of the bond stays exactly even and the manager ultimately sells it at the same price he or she paid. So the return on the investment was 0%, right? Not necessarily. During that same time period, let’s say the value of the British pound fell 5% versus the dollar. When the manager sells the investment, he will have to do so at the pound’s lower price. As a result, the value of the investment actually fell 5%, and the manager ended up losing money.
Questions to Ask Before You Invest
Over time, currency fluctuations can have a meaningful impact on the performance of international bond funds. This is particularly true in the case of emerging-market bond funds since the currencies of the developing markets tend to be more volatile.
It, therefore, pays to research prospective investments to make sure you know exactly what you’re getting. Does the manager maintain full exposure to foreign currencies, or does he or she “hedge” the portfolio to make sure that currency movements have little or no impact? Does the manager take an active approach, shifting the fund’s currency exposure to try to add value? And if so, does the fund’s track record show that this approach has worked well in the past?
As always, the specific investment you choose is based on your individual goals and risk tolerance. If you don’t fully understand what you’re buying, however, you may find yourself with an investment that’s much more volatile than you bargained for.
The bottom line: currency positioning isn’t the primary consideration when choosing an investment, but it’s certainly something that deserves attention.