The Danger of Investing in Foreign Bonds

Many new investors express an interest in diversifying their stock and bond purchases internationally. The logic may seem simple: if you shouldn’t hold all your eggs in one stock,sector, mutual fund or bond basket, why should you have everything invested in your host country and its currency? History, unfortunately, is not quite so logical. Instead of protecting investors, international investments have the potential to wipe out the uninformed thanks a myriad of risks not present in domestic issues.

Three characteristics of foreign bonds

A foreign bond has three distinct characteristics:

• 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 and currency risk

Any time you hold a foreign currency, whether it be cash for vacation or denominated investments, you are subject to currency risk. Simply defined, currency risk is the potential for loss due to fluctuations in exchange rates. Currency risk can literally turn a profit on a foreign investment into a loss or visa versa.

An example of currency risk

An investor purchased a £1,000 par value British bond with a 4 ½% coupon. At the time he made the investment, the currency exchange rate was $1.60 United States dollar to £1 United Kingdom pound (in other words, it costs $1.60 in U.S. currency to buy £1). 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). Unfortunately, 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. The result is he only receives $1,400 for a bond which he purchased for $1,600. The loss of $200 is due entirely to currency risk. (Note that it is possible to profit from currency risk. Had the dollar fallen in comparison to the pound (e.g., the exchange rate went to $1.80 per £1), 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. This, however, is beyond the scope of our discussion as well as the interest of most individual investors).

Foreign bonds represent an unenforceable claim

The primary risk of a foreign bond is that it is an unenforceable claim. An investor that owns the bonds of a company in his or her home country has specific legal recourse in the event of default. Foreign bonds, however, offer no such protection. 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, for example, investors holding bonds in Great Britain were paid interest in pounds yet were unable to convert those pounds to dollars; the money could only be reinvested in pound-denominated investments or spent within the borders of Britain or her colonies.

Eurobonds (global bonds) vs. foreign bonds

There is a difference between 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.