Why Buy Foreign Bonds?
International bonds are a wise investment choice nowadays, when good global diversification is important. This comes to mind in particular as the Super Bowl approaches and I think about the fate of the St. Louis Rams.
U.S. investors and Rams fans have something in common. Both saw their home teams fall from prominence to mediocrity in the past 10 years. In 2000, the Rams won the Super Bowl, but in 2011 they ended the season tied for the worst record in the league.
The U.S. ranked as the world's third freest economy in 2000, but by 2010 had fallen to number 18. For 2013, it is in 10th place. The Heritage Foundation, a research organization, does the rankings based on adherence to the rule of law, limited government, regulatory efficiency and open markets.
How do investors allocate their funds in a country that’s in economic decline? Much like an ardent fan of the Rams who is also an astute gambler. You cheer for your team to win, but you place your bets on the stronger opponents.
Taking a global approach to investing is critical today. Since the U.S. now makes up less than half of the world’s wealth, investing the majority of your portfolio in the stocks and bonds of other countries is sensible. This is simply another form of diversification.
It makes sense to have U.S. government bonds and the bonds from a wide range of companies in your portfolio. It also makes sense to diversify and hold a wide range of bonds of international companies and foreign governments.
While American investors’ exposure to international stocks is not uncommon, their investing in international bonds is unusual.
When you invest in bonds, you lend to a borrower who promises to pay interest and to repay the loan on a certain date. Bonds represent an IOU from a U.S. or foreign corporation or government.
As with any bond, an important factor to consider is the credit quality of the issuer. This can become more complex with foreign bonds, as many countries don’t have the same standards of accounting required in the US.
A unique feature of foreign bonds is the effect that currency exchange rates have on your investment. Fluctuations in the local currency can enhance or depress your returns. For example, if you want to purchase bonds denominated in the Australian dollar, you will first need to exchange your U.S. dollars for Australian currency and then purchase the bonds.
If the U.S. dollar drops in value against the Australian denomination, then the value of your Australian bonds goes up. That’s because your Australian money now buy more U.S. dollars. The reverse happens if the U.S. currency appreciates against the Australian dollar.
There are two ways to purchase international bonds. You can buy bonds directly from a securities broker, or purchase shares of a mutual fund that invests in foreign bonds. Any fund with “international” in its name invests only in bonds of countries outside the U.S. If the fund has “global” in its name, it includes both foreign and U.S. bonds in its mix.
The two categories of international bonds include those issued by developed nations like the United Kingdom, Japan or Germany, and those issued by emerging market nations like India, Brazil or Morocco. Emerging market bond funds invest in bonds from developing nations, risking greater losses for the chance of higher returns.
In my portfolios, I generally split my bond allocations 50/50 between the U.S. and foreign bonds. Currently, our fund manager favors the bonds of Australia, New Zealand and Canada.
The Rams did better in 2012 than in 2011, so fans can hope they regain their top status in 2013. We can also hope the U.S. can stop its economic slide and regain its global prominence in the next decade. But until there is evidence of a turnaround, international bonds are one way to avoid betting too heavily on the home team.
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Rick Kahler, CFP, is president of Kahler Financial Group in Rapid City, S.D.
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