International Bonds
Investing in Foreign Currency Denominated Bonds. IAA is very active in the buying and selling of global securities, many of which are denominated in currencies other than the US Dollar. As a service to holders of such securities and to future purchasers, we list below some of the differences between holding foreign denominated ("FD") with currency being unhedged, vs. US $ securities ("US").
Following the price vs. the price and the rate of exchanged. The par value of a US security is generally expressed as 100. If a US investor buys at that price, he needs to be aware of price dropping below 100 or rising above it; price movements being dependent upon the falling and rising of interest rates. The par value of an FD security is usually set at 100 as well, in local currency, so the investor needs to follow not only price movements, but the rate of exchanged of the currency against the $US. Assuming an investor purchases a US bond at 100, if the price goes to 102, he has a 2% profit. With an FD bond, a move from 100 to 102 in local currency, plus an increase of, say, 3%, in that currency's value against the $US, results in an overall return of about 5$. Of course, a similar fall in the currency would show a current return down about 1%.
$US vs. FD securities-Coupons. If a US investor purchases a US security with a 7% coupon (interest rate) and he buys at 100, he will get 7% per annum for the life of the bond (assuming the issuer has no credit problems and is able to pay). This is true as well with an FD security; however, the $ US amount of each coupon depends upon the currency/$US exchanged rate at the time the coupon is paid. This means his total interest payments in $US might be higher, or lower, than 7%.
Holding US vs. FD securities until maturity. If a US Investor purchases a security at 100 from a credit worthy issuer, and holds the bond until maturity, he will receive exactly what he paid (along with the coupons received over the time he has held the bond). Holding an FD security with the same scenario may have a different result, which, again, will be due to the currency/$US exchange rate at the time the issue matures. This becomes more critical as the bond gets closer to its maturity date. A sudden, short term shift in the exchange rate can have a material effect on the final amount the investor receives in $US. This is why at IAA, we often urge our clients, especially when they are enjoying paper profits on an FD bond, to sell at least a few months before maturity. As short term move up in the $US, especially for technical reasons, might not impact an investor holding an FD bond if he has years left before the bond matures. Such a move; however, when his bond is about to mature leaves no time for the possible recovery of the foreign currency's value.
Holding short term vs. long term FD instruments. The example above demonstrates why we generally urge our clients to invest in longer term FD's. If an investor has a view that the $US is going to fall against a particular currency, by purchasing a longer term maturity, instrument, he has time on his side, to let possible short term upward moves of the $US smooth themselves out. The shorter term the instrument, the less the change of finding out short term fluctuations. This is why we tend to discourage the purchasing of FD CD's/ having a shorter term, if the $ US rise the CD's will wither be sold at a loss or rolled over, often with additional fees being charged. We realize interest rate risk and therefore local currency bond prices are magnified when terms are longer as they are with US securities), but we believe most times that risk is offset by lessening the risk of short term currency fluctuations.
Sovereign risks of US vs. FD securities. This is the risk of holding securities of governments of their agencies. Most investors believe the US government will honor its financial obligations. This is true as well for many industrialized countries. This risk, however, becomes greater with less developed countries. Defaults of countries have been relatively few, but the possibility does exist/ we try to minimize this risk by finding global issuers, such as the World Bank or International Bank for Reconstruction and Development that tend to issue securities denominated in various foreign currencies. This allows the investor to take this currency view while greatly lessening credit risk.
International investing does involve additional risks such as currency fluctuations, differing financial and accounting standards, and possible political and economic instability. As mentioned above, investing in emerging markets can also be riskier than investing in well-established foreign markets. There is no assurance any of the trends mentioned will continue in the future. Investing involves risk and investors may incur a profit or a loss, including the loss of all principal.
Despite the additional risks of foreign currency investing, there are additional rewards as well. Experts in this area can help you to maximize the rewards and minimize the risks. As our name implies, at IAA we are specialists in foreign markets and currencies. This means we can tell whether FD securities are right for you, and if they are, we will take great care in recommending suitable issues which we monitor continuously.
If you are a client and want to know more about foreign currency denominated securities, please contact your Financial Consultant. Otherwise, call us at 800-432-0000 to request information on foreign bonds.