Currency risk, also called FX risk (where FX stands for "foreign exchange"), is the risk that an investment denominated in a foreign currency will lose value as the foreign currency itself loses value against the dollar.
The opposite can also happen—if a foreign currency increases in value against the dollar, this will add to your positive return on investment. Emerging market bonds provide an interesting and potentially profitable example.
- Investors in emerging market bonds can buy dollar-denominated bonds, or bonds denominated in local currencies.
- If a foreign currency increases in value against the dollar, this will add to your positive return on investment.
- Many funds are managed to move between dollar- and local-currency-denominated bonds.
- Investigate any potential bond fund investment thoroughly to make sure you understand the currency denominations of the bonds in its portfolio.
Emerging Market Bonds: Dollar Denominated vs. Local Currency
Investors have two options when it comes to investing in emerging market bonds. The first is to invest in the dollar-denominated debt issued by the world’s developing countries. Dollar-denominated simply means that the bonds are issued in U.S. dollar terms, so U.S. investors do not need to convert to foreign currencies when they purchase the bonds. The result is that there is no impact from currency risk on top of the typical volatility associated with emerging market bonds.
Bonds that are denominated in local currencies rather than U.S. dollars are the second type of emerging market debt. In this case, the investor will have to convert dollars to foreign currency, such as the Brazilian real, prior to buying the bond. The result is that in addition to the price movement of the underlying bond, the value of the investment is affected by currency fluctuations—the rise or fall of the foreign currency/U.S dollar exchange rate.
For example, suppose an investor buys $1 million worth of Brazil’s local currency debt, but to do so they first need to convert their dollars into the local currency. A year later, the price of the bond is exactly the same, but the currency has depreciated 5% versus the dollar.
When the investor sells the bond and converts back to U.S. dollars, that 5% depreciation leads to an additional 5% loss in the value of the investment—even though the nominal price of the bond in reals is unchanged.
Dollar or Foreign-Currency Denominated—Decide Which Is Better
The right scenario for you depends on your own investing needs. The potential benefit of local currency funds is two-fold. First, it allows investors to diversify their holdings away from the U.S. dollar. Second, it allows investors to benefit from the cumulative positive effect of emerging market nations with stronger economic growth.
At the same time, currency exposure adds another layer of volatility. This becomes particularly important during times when investors are looking to avoid risk. On these occasions, it’s reasonable to expect that local currency funds will underperform their dollar-denominated counterparts. Dollar-based debt may, therefore, be the better option in times of uncertainty for new investors in the asset class or for those with lower risk tolerance.
How Performance Differs
An example of how the performance of the two segments can differ: During September 2011, intensifying concerns about the European debt crisis sparked a flight to safety from higher-risk assets. In the midst of this selloff, EMB (the emerging markets ETF that holds dollar-denominated debt) returned -4.9%. In the same time period, ELD (which holds local currency debt) returned -10.2%—a significant difference in such a short period.
Conversely, during the first two months of 2012—an exceptionally positive period for the financial markets, ELD returned 7.6% and trounced EMB’s return of 4.6%. Over time, however, the difference tends to even out. Looking at the two PIMCO funds as an example, the five-year average annual return of the local currency fund (PELBX) and dollar-denominated funds (PEBIX) were 2.49% and 4.39%, respectively, as of Oct. 21, 2021, a comparatively minor difference in the two returns.
Investors Have Many Options
Investors who are looking to allocate a portion of their portfolio to foreign bonds must make a choice between dollar-denominated or local-currency bond funds (or establish some desired combination of the two).
Some fund companies offer both. PIMCO, for example, offers both the PIMCO Emerging Markets Bond Fund (ticker: PEBIX) as well as the PIMCO Local Emerging Bond Fund (PELBX).
In the world of exchange-traded funds, investors can choose between products such as the iShares JPMorgan USD Emerging Markets Bond Fund (EMB) or the Wisdom Tree Emerging Markets Local Debt Fund (ELD).
The Bottom Line
Many funds are managed to move between dollar- and local-currency-denominated bonds. Investigate any potential bond fund investment thoroughly to make sure you understand the currency denominations of the bonds in its portfolio to confirm that the fund fits your risk profile and is compatible with your overall investment strategy.