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Foreign bonds

By David Luhman on Sat, 05/09/2009 - 23:35

Foreign bonds

Although I suggest that you invest in a variety of bonds like US Treasuries, junk bonds and Ginnie Maes to achieve maximum returns at a minimum risk, I don't think there's much to be gained by investing in foreign bonds.

Foreign bond markets may have appeal because foreign markets behave differently from the US bond market. While interest rates may be going up in the United States, they may be going down in Germany. Still, it's doubtful that you can make any extra money by investing overseas.

Currency effects limit chance for gains from foreign bonds

The reason for this is currency risk. If you invest overseas in foreign currency bonds, you may get higher yields, but you're also exposing yourself to currency losses.

And over the long run, what you gain in higher foreign yields will be lost in currency devaluation.

Let's look at an example. In the 1980s American bonds paid higher interest than comparable Japanese bonds.

This is because America had higher inflation than Japan. So if you were a Japanese investor and had invested in American bonds, you would have had higher interest earnings. But, at the same time, you would have seen the value of your American bonds decrease dramatically in yen terms because the yen strengthened against the dollar during this time.

The "Short-term global bond" fiasco of 1992

You would have seen a similar fate if you were an American investor who had invested in Italian or British bonds in 1992 when a lot of new short-term international bond funds were popping up.

These funds promised higher yields than those available in the US, and they delivered on this promise for a short while. But then currency risk caught up with the funds.

I was in Europe in the summer of 1992, and just from comparing Big Mac prices in Italy and Germany I could tell that the Italian lira was overpriced. The market obviously figured this out too, and traders expected the Italian government to devalue the currency.

The Italian government, however, wanted to maintain the lira's standing in the European exchange rate mechanism, so it raised interest rates in Italy. Britain did the same thing. This, however, proved unsustainable and both governments had to devalue their currencies.

So American investors who liked the high yields offered by Italian and British bonds faced losses in principal as their Italian and British bonds suffered currency losses relative to the dollar.

What you gain in yield is surrendered in principal

This provides a general rule for bond investors. Whatever you gain in yield you'll probably have to give up in principal losses. For example, whatever you gain in yield from junk bonds, you'll have to give up as a loss in principal -- at least for the most part. The same holds true for investing in higher yielding foreign bonds.

Of course you can speculate on the direction of foreign bond markets and on foreign currencies by investing in foreign bonds. You might invest at the right time when the foreign bond market is rising and the foreign currency is also rising.

But then again you might get caught in the wrong direction on both accounts. Over time, after translating your earnings back into US dollars, you'll probably do no better than if you had stayed in the US bond market.

Investing in foreign bonds is a losing proposition

In fact, however, you'll probably have done worse than if you had stayed in the US bond market because by going overseas, you subject yourself to higher costs. You'll also subject yourself to foreign taxes. Although you probably can get a credit on your US taxes for foreign taxes paid, why bother if going overseas doesn't get you much anyway?

Hedging and investing in foreign bonds won't help

Finally, don't think that you can earn excess returns by investing in overseas bonds and then eliminate currency risk by using hedges like currency futures or forwards.

In an efficient market, if you invest in a foreign currency and then hedge your currency exposure, there is no way that you can earn more than if you had simply stayed in the United States. This is called the international Fisher effect, and it almost always holds.

So I'd recommend that you not invest in foreign bonds, unless you like to speculate in foreign currencies - an extremely difficult task. However, I do advise that you invest in foreign stocks. Check out my tape on stock investing to find out why investing in foreign stocks is a better idea than investing in foreign bonds.

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