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Understanding How Foreign Bonds Work

Foreign Bonds

The United States is a magnet for investors all over the globe. According to the 10th-anniversary edition of the Venture Capital (VC) & Private Equity (PE) Country Attractiveness Index, the U.S. ranks No. 1 among 125 countries in attractiveness to VC and PE asset class investors. For savvy investors, though, looking outside of the U.S. may be a good option. By branching out from the U.S. domestic market, you can diversify your portfolio and take advantage of their growth. One way to go about this is to purchase foreign bonds. Here is a rundown on how foreign bonds work and their potential challenges to help you make your next investment decision.

For help purchasing foreign bonds or any other investing issue, consider working with a financial advisor.

Foreign Bonds Explained

The issuer of foreign bonds is domiciled in one country but issues the bond in another. This is a common practice that foreign firms use to raise capital. And the more business they conduct in the domestic market, the more likely they are to issue foreign bonds.

These foreign bonds work similarly to domestic bonds. They are essentially loans that investors make to a government or company abroad. In exchange, the investor receives interest payments and their investment back in full when the bond matures.

When they issue them, the foreign entity does it in the local currency. So, if an American company issued an international bond in India, the bond would be in Indian rupees.

What Are the Benefits of Investing in Foreign Bonds?

There are a few factors that make foreign bonds appealing. One of the strongest arguments for a foreign bond is diversification. Consider an investor who invests their entire portfolio into one stock or bond. They may profit temporarily, but they could also lose all of their money if that asset drops in value.

In contrast, having a mix of assets protects you from that. In particular, a foreign bond is not subject to market fluctuations in your country.

Because of this, foreign bonds pose a great opportunity for investors. They help investors gain exposure to foreign economies and companies. By trading in outside countries, you can benefit from their growth. This may be particularly important if the American markets experience a decline.

You likely won’t be able to buy the bond directly as an individual, though. Often, investors interested in foreign bonds need to buy them through bond mutual funds. While that takes some control out of your hands, it means you can pay lower fees for larger bonds. That means you will have a professional managing your foreign investment. While there may be administrative costs, the expertise of your fund manager may allow you to come away more successful.

What Are the Risks of Investing Foreign Bonds?

Investors may find that foreign bonds are a useful way to diversify their portfolio. It also helps them break into foreign investing. Even still, there are some risks to foreign bonds that you should know.

Foreign bonds may come with a higher yield than domestic bonds, but that is due to their risks. For instance, a foreign bond faces potential inflation. When buying a bond at a fixed interest rate, its value depends on the rate of inflation. If an investor buys a bond with a 6% interest rate at a time when inflation is 2.5% then the investor actually makes 3.5% interest on the bond.

Interest rates can also lead to other issues when it comes to bonds. For example, if interest rates rise then the bond’s resale value or market price will drop. To explain, imagine an investor purchases a 5-year bond with a 3% interest rate. If interest rates increase to 4.5%, other investors will want a lower price for the bond because of the smaller income.

You also have to worry about the exchange-rate risk. When you purchase a foreign bond in that country’s currency, you have to exchange it back into U.S. dollars. Sometimes, that may cut into your yield. Take a bond yielding 8% in an Asian currency and turn it into U.S. dollars. A change in the exchange rate may result in a decrease to the bond’s yield. While this risk isn’t implicit in every bond, you still need to think about it. Of course, things can work in the opposite way, which would boost your profit.

Not to mention the repayment risk. Investors need to consider their bond options carefully since not every foreign government or corporation will pay you back. So, a low creditworthy institution risks your principal and interest payments.

Foreign Bond Examples

Foreign Bonds

There are numerous examples of foreign bonds across the globe. For example, you can find Samurai bonds in Japan. Companies and governments issue samurai bonds in the local currency, yen and under Japanese regulations.

One instance of this came in 2017 when the Indonesian government issued 3-, 5- and 7-year Samurai bonds valued at 40 billion yen, 50 billion yen and 10 billion yen. The Indonesian government did so to help boost the country’s infrastructure development program.

Another example of a foreign bond is the kangaroo bond, which is denominated in the Australian dollar in the Australian market. Dubai’s largest bank, Emirates NBD, engaged in a kangaroo bond program valued at A$1.5 billion. In 2018, the bank issued a A$450 million 10-year bond with a 4.75% annual coupon. The bank did this to diversify its sources of funds and branch into new markets.

There are many options worth considering, though, outside the above two examples. There are also matador bonds in Span, bulldog bonds in the United Kingdom, maple bonds in Canada, to name a few.

Should I Invest in Foreign Bonds?

Investing in foreign bonds is one way you can gain more portfolio diversification. That lowers your potential risk of loss if another investment takes a downturn.

In addition, there may be times when the U.S. economy does not perform well. So, even a diversified portfolio can experience loss with all domestic assets. But by branching out into other countries, you can take advantage of their markets’ growth. Thus, you maximize your portfolio’s potential.

However, investing outside the countries or in foreign bonds comes with unique risks. Foreign bonds may not always be lucrative, especially if inflation surpasses their interest rate. You also face default risk if the institution you lend to does not have high creditworthiness. They may fail to pay you your principal back or your interest payments.

In the end, it depends on your risk tolerance and goals. While foreign bonds come with their challenges, they are frequently less risky than stocks. So, they may still be a worthwhile way to expand your portfolio without drastically increasing its volatility or risk.

The Bottom Line

Foreign Bonds

Foreign bonds come with unique benefits, but they also carry their risks. Because of potential loss, you should carefully research your bond options and the credibility of the issuer. If you are unsure where to start, consider reaching out to a financial advisor. A financial advisor can help you choose the right foreign bond for you. Or, they determine it doesn’t fit your goals or risk level, they can find alternative investments. There are other ways to diversify your portfolio, and they can walk you through your options.

Tips on Diversification

  • Setting up your investment portfolio requires you to know what type of investor you are and your goals. A foreign bond may give you the diversification you are looking for, but you might need to find the right one for your risk tolerance. Before you reconsider your mix of investments, try using an asset allocation calculator. It provides you with insight into different portfolios based on risk tolerance.
  • Foreign bonds can be risky if you aren’t careful. A financial advisor has the know-how to guide you through your purchase and investment. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

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