The attraction of foreign bonds

As yields on high-quality bonds have slipped in the United States, more investors are turning to foreign bonds and foreign bond funds to boost portfolio yield potential and provide greater diversification.

 In the past decade, there’s been substantial growth and maturation of world bond markets. That, combined with the ongoing globalization of businesses and capital flow, can make foreign bonds a viable option for many investors. In fact, nearly 75 percent of the world’s sovereign debt is issued outside of the United States.

Investing in foreign bonds has many advantages, including:

• Increases diversification of an investment portfolio. Foreign bonds may help reduce exposure to economic or political instability in a specific country and can improve a portfolio’s risk profile.
• Hedge against a weak or falling U.S. dollar. When a foreign currency is strong compared to the dollar, your returns increase because your foreign earnings convert into more dollars.
• Attractive yield potential. Returns from foreign bonds are typically higher than returns offered via U.S. Treasury securities. However, it’s important to note that with those attractive yields come additional risks —the risk of changing political conditions and fluctuating currencies —which are generally not factors when investing in domestic debt.
• Less correlation. The monetary and budget policies of many foreign nations are often unsynchronized with those of the United States, which can be a good thing from the standpoint of portfolio diversification.

Over time, foreign bonds have produced competitive returns, even besting the equity market at times. In the 10 years ended August 31, 2012, average total returns of foreign bonds have outperformed the Standard & Poor’s 500, and over the past five and ten year periods, have outpaced the U.S. bond market.

Citigroup Non-US Dollar World Government Bond Index

Barclays US Aggregate

Bond Index

S&P 500

1 Year

            -1.76%

          5.78%

          18.00%

5 Year

             6.77%

          6.67%

            1.28%

10 Year

             7.00%

          5.48%

            6.50%

Sources: Citigroup, Barclays, Standard & Poor’s. Data as of August 31, 2012. It is not possible to invest directly in an index. Past performance is no guarantee of future results.

One caveat: While the U.S. and foreign bond markets have not consistently moved in sync in the past, in recent years the correlation between them has increased. From 1986 through 1999, the correlation was 0.31 between international bonds and U.S. bonds. Between 2000 and 2011, the correlation rose to 0.55. The closer the correlation moves to 1, the more that U.S. and foreign markets have moved in tandem.

There are many types of foreign bonds, both from government entities as well as corporations. Here is an overview.

Eurobonds

A eurobond is a bond issued and traded in a country other than the one in which its currency is denominated – not always a European nation. Eurobonds are attractive financing tools as they give issuers the flexibility to choose the country in which to offer their bond according to that country’s regulatory constraints. They are usually issued in more than one country of issue and traded across international financial markets. But they are unsecured, leaving bondholders without the first claim to the issuer’s assets in case of default.

Below are some common types of eurobonds.

• Straight eurobonds – This type of bond has a fixed coupon that is usually paid annually and returns principal at maturity, which is typically between three and seven years.
• Floating rate bond notes – Short- to medium-term bond issues that pay a coupon interest rate that “floats” (goes up or down in relation to a benchmark rate plus some additional spread).
• Zero-coupon bonds – This type of bond does not have interest payments – instead interest is paid at maturity. This bond is typically purchased at a discount. Investors in this type of Eurobond may be looking for some kind of tax advantage.
• Convertible bonds – This type of bond can be exchanged for another instrument, usually a share of stock from the issuing organization. The bondholder decides whether to convert the bond.
• High-yield bonds – Rated to be below investment grade (a credit rating below BBB by Standard & Poor’s or Baa by Moody’s)

(More on foreign bonds tomorrow.)