Many people are interested in globally diversifying their bond purchases. This can be done by investing in foreign bonds. The logic is simple: We all know you shouldn’t hold all your eggs in one stock, sector, mutual fund, or any other type of basket. So 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 more than one currency. If the political system collapses and you can escape, you might not have to start over from scratch; it depends on how you held these foreign investments.
But in practice, investing in foreign bonds can be risky for the novice.
Foreign Bonds: Know the Risks
It's easy to get wiped out in the blink of an eye when dealing outside the relatively safe borders, laws, and political climate of the U.S. or Canada. This is even more true with fixed-income securities such as bonds. If your foreign bonds lose value relative to the U.S. or Canadian dollar, you wind up with less purchasing power in your native market.
Wars, coups, international sanctions, hyperinflation, depressions all happen; sometimes, they happen without warning. It can be hard to protect your money from halfway around the world.
From afar, you will also be at a disadvantage compared to investors actually living in the country. A native Japanese speaker living in Japan can read the annual report of a Japanese business, for instance. They will have an easier time understanding subtle shifts in the inputs to financial ratios such as the interest coverage ratio.
Let's look at some of the aspects of investing in foreign bonds. That way, you can get a better idea of why it might not be wise until you are much more experienced.
3 Characteristics of a Foreign Bond
These are the three main characteristics of a foreign bond:
- The bond is issued by a foreign entity. This could be a government, municipality, or corporation.
- The bond is traded on a foreign financial market.
- The bond is denominated in a foreign currency (although, many foreign bonds are denominated in U.S. dollars).
Why Do Foreign Bonds Present Enhanced Currency Risk?
Any time you hold a foreign currency, you are subject to currency risk. It doesn't matter whether it's cash for trips to Europe or denominated investments as part of a portfolio,
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 vice versa.
An Illustration of Currency Risk
Let's say you bought a £1,000 par value British bond with a 4.5% bond coupon. At the time you made the investment, the currency exchange rate was $1.60 U.S. dollar to 1.00 British pound sterling. In other words, it costs $1.60 in U.S. currency to buy 1.00 British pounds. This means that you paid $1,600 for the bond.
Several years later, the bond matures. You are promptly issued a check for the par value of the foreign bond (1,000 British pounds). Unfortunately, when you go to convert those funds to dollars so you can spend them back in the U.S., you discover the currency exchange rate has fallen to $1.40 to 1.00 pounds.
The result? You only receive $1,400 for the foreign bond, which you purchased for $1,600. The loss of $200 is due to currency risk.
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 pounds—you would have received $1,800, or $200 more than you 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.
An Unenforceable 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 unenforceable claim.
An investor who owns bonds issued in their 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 1970s) 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.
Eurobonds vs. 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.