Jean Claude Trichet, President of the European Central Bank, piqued the interest of some US investors who continue to battle record low yields by saying he may raise interest rates in the Eurozone when the ECB meets in April. The second installment of my series entitled “No Free Lunch” will focus on how chasing international bond yields can leave investors exposed to more than just a bond.
Almost all government bonds are denominated in the currency of the issuing country. Foreign investors who buy the bonds are exposed to the traditional risks of a bond, in addition to foreign currency risk. The example below looks at the case of a US investor considering a US Dollar denominated Treasury Bond and a Euro denominated German Bund. Germany is rated AAA by S&P.
The US investor must first convert their money to the foreign currency in order to buy foreign government bonds, and then convert back to their home currency after the bond matures. In addition to the bond itself, which will fluctuate in price and pay interest like any bond, volatility in the exchange rate between the investor’s home currency and the foreign currency will contribute to performance. In fact, over the life of the investment the currency volatility could far outpace the yield on the bond, and become a much larger factor influencing performance than the cash flow, making the investment above way less about earning an extra .5% in yield and way more about changes to the USD/EUR exchange rate.
I highlight a few of the major moves in the Euro versus the US Dollar from the last 12 months in the graph above. The “PIIGS” crisis has made the Euro especially volatile, which has translated into wild swings for foreign holders of Euro denominated debt like German Bunds. Exchange rate fluctuations involve a lot of moving parts that are beyond the scope of what I’m trying to say here. Maybe delving deeper into the subject would be a good topic for a future article.
Foreign governments also issue debt denominated in currencies besides their own in order to gain access to lenders unwilling to risk converting their currency. (For example: A USD denominated bond issued by Germany) These securities have different risk characteristics than bonds denominated in the country’s local currency; specifically the country’s ability to purchase other currencies in the open market to pay interest and principal. That said, even though you aren’t taking direct currency risk when buying a foreign bond denominated in your home currency, instability in the currency market can still effect your investment.
This is just the tip of the iceberg when it comes to looking at foreign bonds. There could be some diversification benefits to spreading credit risk across different foreign governments, but foreign exchange exposure is completely different and must also be considered.
Cliff J. Reynolds Jr., Investment Analyst