Investing in Foreign Bonds Can Be Dangerous
Understanding the Additional Risks of Foreign Bond Ownership
Many beginning on their path to financial independence express an interest in globally diversifying their bond purchases by investing in foreign bonds. The logic is simple: If you shouldn’t hold all your eggs in one stock, sector, mutual fund, bond fund, or other proverbial basket, why have everything invested in your home country and native currency? Why not diversify against inflation and political risk?
In theory, this is a great idea. If you invest in foreign bonds, you'll be collecting interest income in multiple currencies. If the political system collapses and you can escape, you might not have to start over from scratch depending on where, and how, you held these foreign investments.
However, in practice, investing in foreign bonds can be extremely dangerous for the novice. It can be disturbingly easy to get wiped out in the blink of an eye when dealing outside the relatively safe borders, laws, and political climate of the United States or Canada, especially with fixed income securities such as bonds. It can be horrifying to find that your foreign bond investments are generating passive income in a currency that has lost value relative to the United States or Canadian dollar, meaning you have less purchasing power in your native market to pay your mortgage, buy groceries, take a vacation, or cover your health care costs.
Wars, coups, international sanctions, hyperinflation, depressions; all happen, sometimes without warning, and it can be impossible to protect your money from halfway around the world. This is especially true when you consider that from afar, you will be at a significant disadvantage to investors actually living in the country.
A native Japanese speaker living in Japan and reading the annual report of a Japanese business in Japanese is going to have an easier time understanding subtle shifts in the inputs to financial ratios such as the interest coverage ratio than a foreigner is.
Let's take a moment to examine some of the aspects of investing in foreign bonds so you have a better idea of why it might not be wise until you are much more experienced and knowledgable.
The Three Characteristics of a Foreign Bond Investment
A foreign bond investment has three distinct characteristics that make it unique from an ordinary bond investment. These are:
- The bond is issued by a foreign entity (such as a government, municipality or corporation)
- The bond is traded on a foreign financial market
- The bond is denominated in a foreign currency
Foreign Bonds Present Enhanced Currency Risk
Any time you hold a foreign currency, whether it be cash for trips to Europe or denominated investments as part of a portfolio, you are subject to currency risk. Simply defined, currency risk is the potential for loss due to fluctuations in exchange rates between the currency you hold and the currency you will require, ultimately, to pay your bills, debts, or other cash outflows.
Currency risk can literally turn a profit on a foreign investment into a loss or visa versa.
An Illustration of Currency Risk
An investor purchased a £1,000 par value British bond with a 4 ½% bond coupon. At the time he made the investment, the currency exchange rate was $1.60 United States dollar to £1.00 United Kingdom pound sterling (in other words, it costs $1.60 in U.S. currency to buy £1.00). This means that he paid $1,600 for the bond.
Several years later, the bond matures. The investor is promptly issued a check for the par value of the foreign bond (£1,000). To his dismay, when he goes to convert those funds to dollars so he can spend them back in the United States, he discovers the currency exchange rate has fallen to $1.40 to £1.00. The result? He only receives $1,400 for his foreign bond, which he purchased for $1,600.
The loss of $200 is due to currency risk.
(Note that it is possible to profit from currency risk. Had the dollar fallen in comparison to the pound sterling - e.g., the exchange rate went to $1.80 per £1.00 - the investor would have received $1,800, or $200 more than he paid. Unfortunately, currency speculation is just that - speculation. Currency exchange rates are moved by a number of macroeconomic factors including interest rates, unemployment data and geopolitical events, none of which can be accurately predicted with any reasonable certainty. Furthermore, professional investors and institutions can guard against currency fluctuations by engaging in certain hedging practices that can be prohibitively costly to the small individual investor. This is beyond the scope of our discussion.)
Foreign Bond Investments Often Represent a Non-Enforceable Claim
The primary risk of investing in foreign bonds, whether it be a sovereign bond issued by a government or a corporate bond issued by a business, is that it often represents to what amounts to an non-enforceable claim.
An investor who owns bonds issued in, and secured by assets of an issue within the borders of, his or her home country has specific legal recourse in the event of default. If you own the first mortgage bonds of a railroad secured by a specific group of assets on the railroad's balance sheet, and the bonds go into default, you can drag the issuer to court and demand the collateral that secures the bond.
Foreign bonds may seem to offer the same protection on paper but it is often illusionary. An extremist political movement (e.g., Iran in the 1970’s) could come to power and seize or deny all foreign assets and claims. A country may become engaged in a military conflict and prohibit its currency from leaving its borders. After World War II, investors holding bonds issued in Great Britain were paid interest in pound sterling and forbidden to convert those pound sterling to dollars. The money could be reinvested exclusively in pound-denominated investments or spent within the borders of Britain or her colonies; cold comfort to a widow in New York who needed those funds to purchase fuel for the winter.
Investing in Eurobonds (Global Bonds) vs. Investing in Foreign Bonds
On a final note, it is important to highlight the difference between a so-called eurobonds and foreign bonds. A eurobond is a bond issued and traded in a country other than the one in which its currency is denominated. A eurobond does not necessarily have to originate or end up in Europe, although most debt instruments of this type are issued by non-European entities to European investors.
Examples of Eurobonds
1. Wal-Mart issues bonds denominated in U.S. dollars on the German financial markets.
2. The French government issues euro-denominated bonds on the Japanese financial markets.