Despite the hype, foreign bond investing is not a slam dunk. Before you jump in to purchase foreign bonds, there are issues you have to evaluate.
Some U.S. investors purchase foreign currency denominated bonds because they have a use for that currency. They might be expatriates that spend a lot of time in another currency zone or a businessperson who can adjust to and benefit from currency movements.
If you are an average investor who lives in a dollar-denominated environment, then you can get caught in “currency wars” as countries try to manipulate their currency in order to remain competitive exporters. For example, you may purchase Brazilian bonds because the yield is 12 percent. However, the Brazilian government might attempt to stem inflation resulting in a decline in the Brazilian currency, eroding your gains or creating a loss. You also don’t know if some large hedge fund has placed a currency bet that might affect your position adversely.
The differences in yield between U.S. dollar-denominated debt and foreign-currency debt of the same nation are quite revealing. For example, in 2006, the bonds denominated in Turkish lira due in 2007 yielded about 14.7 percent, while the dollar-denominated debt yielded 5.2 percent. The higher yield did not guarantee that you would earn more because the value of the Turkish lira was at risk and actually devalued 6.1 percent against the U.S. dollar.
If you own stock of a foreign (non-U.S.) corporation or a fund that holds foreign stock, dividends and capital gains generated by the stock may subject you to tax in the foreign country. The amount of this foreign tax may be reduced or eliminated by a tax treaty between the United States and the foreign country. In addition, any foreign taxes paid by you may give rise to a foreign tax credit in your U.S. federal income tax return that may reduce your federal income taxes.
Interest income on U.S. bonds received by foreign investors is generally exempt from U.S. tax and U.S. backup withholding if the interest income is from the following categories: government debt, corporate debt obligations issued after July 18, 1984, tax-free municipal debt, Build America Bonds, or from any foreign stock or bond.
With interest rates low in the United States in 2009 and 2010, foreign currency bonds looked very attractive. However, an investor needs to consider the exit strategies before jumping in, unless you have an ongoing use for the currency.
If you can obtain an income stream from a foreign bold held in a foreign currency and have the opportunity to spend it in a foreign country, that might be advantageous. For some, the opportunity to hedge against a falling dollar is worth the additional risk.
You can lose money if the foreign currency declines against the U.S. dollar, the credit quality of the issuer of the bonds falters or fails, federal taxes on foreign purchases increase (as they did in Brazil in October 2010), capital controls are put in place restricting the ability to move money, currency controls limiting your ability to convert to another currency, and hot money flows out of the country or out of emerging markets altogether.
The risk are real. There may be no warning when a foreign bank fails. There also may be no equivalent to Federal Deposit Insurance Corporation (FDIC) insurance in the United States, to bail out your investment. Finally you are still exposed to adverse movements of the currency in relation to the U.S. dollar.
If you decide to diversify by purchasing a bond fund–international, foreign, global, or emerging market–you should have an idea what the fund contains.
Consider the following questions before investing:
- What is the likelihood that the dollar will fall in relation to the currency in which I propose to purchase bonds?
- Am I purchasing dollar-denominated foreign bonds?
- What is the past history of default on the bonds of the country?
- What class of bonds would I consider buying? Sovereign, subsovereign, corporate or mortgage-backed securities?
- If it is a fund, how much leverage is used?
- What is the credit quality?