With Greece’s Troubles in Mind, Should You Invest in Foreign Bonds?

 (*JRFoto*)

You barely need to glance at the headlines screaming of Greece’s troubles to question the idea of investing in foreign bonds.  When issued by a country, bonds are basically a way for the government or companies in that country to borrow money — from its own  investors (institutional or individual) or those of another country.  As the current situation with Greece’s debt (and that of other countries, including Portugal) shows,  those investments aren’t always as safe as the name “bond” tends to imply.

Yet, investing in foreign bonds offers a number of advantages. One is that foreign bonds can effectively provide a hedge against a falling U.S. dollar. Bond income from countries with stronger currencies can help offset the damage done by a weaker dollar at home.

Foreign bonds can also help protect one’s portfolio from inflation, which has historically been a single-country phenomenon. More broadly, bonds of other countries are generally insulated from American recessions and political risk, making them a favored diversification tool.

There are important differences between foreign and U.S. bonds which you need to understand before investing.

Corporate vs. Government Bonds

The first decision you’ll need to make is whether to invest in corporate or government bonds of the country in question. Your choice will largely be based on your risk tolerance and primary objective: stability or growth.

Most people, when discussing foreign bonds, are actually talking about government bonds (which are roughly similar to the savings bonds sold by the U.S. Treasury). The primary advantage of investing in foreign government bonds is the same as investing in U.S. government bonds – security and stability. Most developed nations’ governments are unlikely to default on their debt obligations (which is what bonds represent) — more so than even a well-established corporation.

Because foreign corporate bonds are inherently riskier, they offer higher yields.  Foreign government bonds, unfortunately, are not always accessible to smaller investors. As eHow.com explains, there is “usually a minimum of 10,000 face-value units of whatever the country’s currency is” in order to buy foreign government bonds.

Mutual Funds vs. Individual Bonds

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Whether to own specific foreign bonds individually or clusters of them within mutual funds is another crucial choice. As a general rule, foreign bonds are inherently riskier than U.S. bonds because foreign bond holders do not have legal recourse. An invading power, extremist political movement or a war could render a foreign bond holder’s claims unenforceable. This suggests that buying into a pool of bonds is smarter from a risk-management standpoint. Unfortunately, as MSN Money points out, many so-called world bond mutual funds combine foreign bonds (both corporate and government) with U.S. bonds. This can dilute your return, weaken your diversification and lessen the domestic risk management that foreign bond investing provides. A better approach is investing in funds that buy only foreign bonds, which do not simultaneously hedge foreign currencies (more on that later.)

As a practical matter, it is also somewhat difficult to buy foreign bonds individually. While the U.S. sells bonds directly to the investing public via the Treasury Direct program, there are few if any equivalent methods for direct bond buying in foreign countries. Online brokerage firms (even larger ones) frequently have few or no foreign bonds to sell you. According to eHow.com, it is often possible to pay less in commissions and markups and get higher interest rates by buying bonds within the country in question, using the currency of that country. Those wishing to invest in foreign bonds without expending the time or effort to buy them individually should instead use international bond funds. Buy into a high-quality fund and hold it for the long-term.

Currency Hedging

(Photos8.com)

Another critical factor to address when choosing foreign bond funds is whether the fund in question hedges against currency risks. Foreign bonds, like U.S. bonds, fluctuate in value depending on interest -rate movements in the countries issuing the bonds. (Obviously, if you purchase an individual bond and hold it to maturity, that doesn’t concern you: you will get your promised yield no matter what.)

In recent years, for example, the Euro’s strength relative to the weakened U.S. dollar have made many European bonds an excellent investment. But on the downside, there is the risk of a declining Euro or other foreign currency having the opposite, depressing effect. Some international bond funds address this risk by hedging against currency fluctuations by using futures contracts or participating in the foreign exchange markets. This allows fund managers to invest solely based on interest rate considerations and effectively ignore currency risks.

Not every international bond fund hedges against currency risk. Some fund managers argue that one of the basic reasons for investing in foreign bonds is precisely to have exposure to one or more non-U.S. currencies. By pegging the investment performance of an international bond fund to a domestic currency negates this core tenet of foreign-bond investing in the first place. There is a wide range of opinion whether to hedge or not in foreign bond investing. Discuss it with a broker.

The Takeaway

Despite the advantages foreign bonds offer, they remain somewhat riskier than U.S. investments in general and U.S. bonds in particular. This should be reflected in the percentage of your overall asset allocation that consists of foreign bonds. CNN reproduced a chart from Vanguard founder John Bogle suggesting that 10% of your portfolio be devoted to foreign bonds.