Should invest in foreign bonds? I mean, most investors know that bonds can provide your portfolio with safety and security. Especially, government bonds.
But here’s the thing. It’s generally agreed that you should invest in the government bonds of your base currency, to avoid currency risk and credit risk. For example, a UK investor would buy UK government bonds denominated in pounds and avoid foreign bonds.
So where do bonds of a foreign nature come into it?
I said generally before, because this idea of investing in your local bonds comes with a caveat: Your base currency has high quality government bonds available. By that, I mean you live in a country or plan on living in a country that has investment grade government bonds available in the currency of that country.
Taking a UK resident as an example, they could just invest in UK Government bonds, which are denominated in the pound. In fact, you don’t necessarily have to invest in your resident country’s bonds. Foreign bonds denominated in the same currency would still work equally well.
An example of this might be a Greek resident who decided to invest in high quality foreign bonds in the eurozone. They could invest in German government bonds. Both German and Greek bonds are euro denominated, but German bonds might come with a higher level of creditworthiness.
A bond’s creditworthiness is determined by rating agencies. Two of the biggest rating agencies are Standard & Poor and Moody’s. A Standard & Poor rating of BBB or above and a Moody’s rating of Baaa3 or above signifies investment grade. Ratings below these are considered non-investment grade.
Non-investment grade bonds also go by the names of high yield bonds or junk bonds. The clue is in the name! They generally yield higher than investment grade bonds, but they are a lot less creditworthy hence ‘junk!’
High quality government bonds really need to be at least AA. At the time of writing, the UK is rated AA and the US AA+. There are plenty of countries with triple A rated bonds, though.
Australia, Canada, Denmark, Germany, Liechtenstein, Luxembourg, Netherlands, Norway, Sweden and Switzerland are all triple A right now.
Plenty of investors really don’t have a decision to make. They can simply buy their own country’s bonds. American investors can buy US bonds, UK investors can buy UK bonds and so on.
However, what about people who live in countries that don’t have their own highly rated government bonds? What about expats who are living or planning to retire in countries that don’t have such high quality bonds available?
Such investors, either living in or planning on living in countries without high quality government bonds have a big decision to make. If you are such an investor you need to decide whether to take on credit risk, currency risk or both.
Some investors may be willing to invest in their own country’s bonds, even through they are not highly rated. When they do this, they are exposing themselves to credit risk. The likelihood of them not getting all their money back increases. Even governments default on their debt sometimes!
The alternative is to buy foreign bonds. However, when you buy these you expose yourself to currency risk.
If somebody living in the UK and somebody living in the US each bought a $100 dollar bond which pays $1 a year, they would both be sure to have $101 after one year.
For an American the value of $101 dollars is unquestionable. It is $101! For somebody living in the UK however, the value of $101 dollars must first be exchanged into pounds before the true value can be assessed, and here lies the risk.
Right now, the exchange rate is about £0.8 to $1 so $101 dollars is about £81. We would expect to receive £81, but what if the price of the pound moved against the dollar. If the pound strengthened against the dollar so that $1 was worth £0.6, then $101 would only be worth about £61, which would be terrible for an investor. They’d have lost about £20.
Alternatively, if the value of the pound weakened against the dollar and £1 became equivalent to $1 then $101 would be worth £101, which would be great for an investor because they would have made about £20.
Currency exchange rates can be pretty volatile. During the Brexit vote the pound dropped 10% compared to its high against the dollar in a single day.
In an ideal world, investors would want to avoid this currency risk associated with owning foreign bonds, but investors living in a country without high quality government bonds may not be able to. They will usually need to take on some form of risk.
Here are a few options:
- Invest in resident country’s government bonds and take on credit risk.
- Invest in foreign bonds from one or more countries and take on currency risk.
- Invest in resident country’s government bonds and invest in foreign bonds from one or more countries, where you take on credit risk (but not as much as in option 1) and currency risk (but not as much as with option 2).
As an example, let us say you are going to retire in the world’s second largest economy, China.
If you followed option 1, you would simply invest in Chinese government bonds and take on credit risk.
If you followed option 2, you could invest in the highly rated government bonds of your choice such as the US, UK or Germany or you could use a fund to invest in many different developed countries highly rated government bonds. In either case you would be taking on currency risk.
If you followed option 3, you could invest in both of the above. Perhaps, Chinese government bonds alongside a fund of developed countries’ highly rated government bonds. With this option you take on some credit risk and some currency risk.
A final point worth mentioning is hedging. Depending on your retirement destination you might consider buying foreign bonds that are hedged in that currency if they are available. The problem here is, you are essentially left with the bonds of that currency, which rather defeats the object.
As an example, say you live in China and buy US government bonds that are hedged against the Chinese yuan. In effect, you are essentially buying Chinese bonds.
I’m sure there’ll be some difference in there somewhere, but it isn’t likely to be a lot and you are going to be paying for it. Hedged bonds are likely to cost more than unhedged.
Personally, I would probably go with a global fund of foreign bonds, this way you spread your currency risk over a number of currencies and avoid credit risk.