Think outside the Box to Find Yields: A Look at Foreign Bonds
When asked what the most important traits of a successful investor are, Warren Buffett provided this list: Independent thinking, emotional stability, self-confident, passionate about investing, long-term thinker, good common sense, curious, and disciplined. These characteristics describe individuals who are proactive in their investing rather than letting the markets’ free falls just happen to them.
You might also call it thinking outside the box. In today’s markets, outside-the-box thinking might include forays into foreign bonds and bond funds. Foreign bonds are issued by foreign corporations, municipalities or governments and are traded on foreign financial markets rather than markets in the US. Moreover, they are denominated in a foreign currency.
Investors may be attracted to foreign bonds and bond funds because they can offer higher yields and greater diversification than the domestic ones. For instance, the returns are typically higher than those of US Treasury securities. Diversification is achieved because most foreign nations’ monetary and budgetary policies are not synchronized with that of the US. Since investors in foreign bonds are typically from other countries, such as the US, they seek these investments to add content to their portfolios, and they don’t have the added exposure to exchange rate issues.
The downside is that most foreign bonds are not guaranteed as to timely payment of principal and interest. They also come with a number of risks, although some are less risky than others. For instance, “sovereign bonds,” which are issued by national governments, are considered safer than their domestic alternatives. “Eurobonds” are attractive because they have small par value and high liquidity. These by definition are traded in a country other than the one in which its currency is denominated.
Let’s look at some of the risks of foreign bonds.
Currency risk—Any time you hold a foreign currency, whether it is 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. This type of risk can literally turn a profit on a foreign investment into a loss—or vice versa.
Foreign bonds represent an unenforceable claim—This means an investor who owns the bond of a company in his or her home country has specific legal recourse in the event of a default. But foreign bonds do not offer this protection. For instance, if a country became engaged in a military conflict, it could prohibit its currency from leaving its borders.
The risk of inflation—Simply put, bonds lose value in the secondary market as inflation rises.
The risk of rising inflation rates—Since buyers are seeking yield, as interest rates rise, bond prices fall as investors can realize greater yields by buying newly issued debt that reflects the higher interest rate.
Sovereign risk—Sometimes a government will be unwilling or unable to meet its loan obligations. Emerging markets are particularly risky since their governments can be unstable.
Investors looking to get into foreign bonds and bond funds should research them thoroughly. There are many variations and categories, including Eurobonds, Global Bonds, Sovereign Debt, Yankee Bonds and more. Some are issued by governments, others by corporations. Some have nicknames such as bulldog bonds, matilda bonds and samurai bonds.
Assessing your current risk temperament should be the first step in taking the plunge into foreign bonds. And, as with any new investment, ensuring that your purchase fits well with your existing holdings is key to a healthy portfolio in the years ahead.
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Provided by courtesy of Herb White, MBA, CFP®, a CERTIFIED FINANCIAL PLANNER™ with Life Certain Wealth Strategies, 8400 E Prentice Ave, #715 Greenwood Village, Colorado, www.lifecertain.com, (303) 793-3999. Securities and investment advisory services offered through Woodbury Financial Services, Inc. Member FINRA, SIPC and Registered Investment Advisor. Life Certain Wealth Strategies and Woodbury Financial Services are not affiliated entities.