A recent article at SmartMoney.com promotes the idea of buying foreign bonds. The article notes that many foreign countries are in great financial shape, some have more assets than liabilities, leaving no question about their solvency. Many issues pay higher coupon rates than US Treasuries, notably Norwegian bonds, which yield 2.5% on a 10 year, compared to the US 2% yield.
Buying individual bonds is difficult for an individual investor. Information about the bonds generally only arrives twice a year – when you receive your coupon payment. The market is opaque and dealer driven. While some brokers have online bond search tools, these are generally ill suited to the nature of the market, where a dedicated fixed income desk can add a lot of value. Also, in a pinch, it may be hard to get a good price when selling a bond.
Also, unless you have the money to dedicate to a sufficiently diverse array of bonds (generally about 10 issuers, at 25 bonds of $1000 a piece = $250,000) you risk losing a significant chunk of your money to a single default. If you don’t think default risk is that big of a deal, just think, the Euro has been around about 10 years and already the bonds of Ireland, Portugal, Spain and Italy have suffering varying degrees of distress, not to mention Greece, which looks likely to suffer a default of sorts soon. This sort of volatility wouldn’t sit well with the average fixed income investor.
Foreign bonds do offer advantages to US bonds, of course, but there is more than just yield. Besides the general pros and cons of treasuries or corporate bonds, foreign denominated bonds offer the chance to participate in any change in the currency’s value. An American investor would benefit from this currency bet if the dollar depreciated, and lose out if the bond’s currency depreciated. This may not be a bet that the average fixed income investor wants to enter into.
This is what it looks like when you want to buy foreign bonds. Does this make sense yet?
For American investors, building a ladder of carefully selected individual bonds can be a great way to spend $250,000 and have fairly reliable cash flows effectively in perpetuity (rolling over matured bonds into the longest maturity desired). This is key for the investor who needs to generate stable income from their portfolio. However, not everyone needs bonds for income, or has that much to invest. In that case, funds may be the way to go.
There are two main uses for bonds in an investment portfolio: to generate cash flow and to act as a diversifier. As far as cash flow, individual bonds are a great idea. Without paying fund fees, working with a broker, one can build a portfolio which only needs tending to once a year and squeezes a few extra basis points of yield over the broader market. Again, this is an expensive option, so the smaller investor may want to turn to funds, where a professional (or a computer) takes care of all the selection process for you and pays out interest to you from time to time.
The main benefits of foreign bonds over domestic bonds is diversification. While in general, bonds will act like bonds, foreign bonds offer currency and inflation characteristics unlike domestic bonds. In this way, they can form a unique asset class in your portfolio. Big bond names like BlackRock and PIMCO offer mutual funds covering developed and emerging market bonds. Templeton also offers a Global Bond Fund and a Total Return cousin which spreads its bets worldwide for a reasonable cost to the investor. With the growth of ETFs in this area, it is even easier to add foreign or emerging market bonds into your investment mix with WisdomTree’s Emerging Market Local Debt Fund or PowerShares Emerging Markets Soverign Debt Fund.
The author at SmartMoney has a great point: foreign denominated bonds do offer some benefits over US Treasuries, but it is important to consider the risks too, before jumping at the extra basis points of yield. Importantly, with fixed income, the way one chooses to invest can have a huge impact on performance. If you are interested, talk to a Registered Investment Advisor about the appropriateness of holding foreign bonds.
