The Basics Of Investing In Foreign Government Bonds

By Marc L. Ross, CFP, CPA®, CLU® | April 04, 2012 AAA
The Basics Of Investing In Foreign Government Bonds

The United States' government paper currently throws off little, if any, yield. Accommodative monetary policies in the wake of the financial crisis that befell the U.S. and the world in the later part of the 2000s, were to put the economy back on its feet. Progress is palpable, but slow. Savers who have purchased treasury bills (T-bill), notes and bonds have no credit risk - and little else for that matter (results from the latest T-bill auction put yields of a six-month paper at around 0.10%).

SEE: Playing It Safe In Foreign Stock Markets

Foreign Government Securities
Some investors have sought to purchase individual foreign government bonds (or sovereign debt) in an effort to obtain greater yield. When a government issues bonds, it borrows money and becomes a debtor. The investors who buy these bonds are the government's lenders or creditors. Individuals contemplating the purchase of government bonds need to understand the risks of bond investing in general, and of foreign government bond investing in particular.

Risk
Bonds are subject to interest rate risk. Interest rates and bond prices are inversely correlated. When one goes up, the other goes down. This may not matter if an investor buys and holds a bond to maturity. In this case, it would collect the scheduled coupon payments and receive the face value when the bond is repaid.

Foreign government bonds may also be subject to credit risk. Does the government have the resources to meet its obligations? Are finances (mis)managed? The example of Greece is as telling as anywhere - the foregoing considerations point to the ongoing possibility of default. In this case, greater yield reflects the bonds' "junk" status, is punitive in consequence, painful for the debtor and of questionable benefit for the bondholders.

Moreover, government bonds are vulnerable to political risk. While governments don't necessarily go out of business, instability may result in a regime change which could affect how well an interim or new government may pay its bills.

Government bonds bear economic risk. A government's fiscal policy, (im)proper use of its natural resources, if any, and current account earnings, all weigh on how it meets its responsibilities. These factors, in turn, affect the bonds' yield.

In addition, currency risk can affect the value of government bonds. If the investor is keeping score in dollars, their strength or weakness relative to the currency in which the bonds are denominated can affect the total return (income and price appreciation). Mitigating the currency risk through hedging may negatively impact return.

Considerations
These few considerations alone make the analysis and purchase of individual foreign bonds beyond the ken or ability of most individual investors. Additionally, one may have to go to the trouble of setting up an offshore account, and typically be required to invest at least the equivalent of $100,000 in the foreign currency. As foreign paper trades less frequently, the bid/ask spread is high (the difference between what the middleman pays to buy the bonds and the price for which they sell them to the investor). Such activity entails fees and tax implications as well. Unlike purchasing U.S. treasury securities directly, it's complicated; the individual investor needs to do their homework, seeking out a professional money manager with experience in analyzing and trading bonds.

For an individual retirement account or non-qualified account (e.g., standard brokerage account), a foreign government bond, mutual fund or exchange-traded fund are possible options. ERISA-qualified defined contribution plans generally offer foreign government securities in the form of a mutual fund. For non-qualified accounts, a check or wire to the brokerage firm in accordance with the purchase and settlement terms would be required. For the qualified plans, purchase would be through a salary deferral arrangement or through an employer contribution, the latter for matching, profit sharing or money purchase pension plan contributions.

Active Vs. Passive Management
When making this choice, the investor should understand the difference between active and passive management. Active management entails the purchase, holding and selling of investments to meet a fund's objective. Passive management, by contrast, involves tracking an index of stocks or bonds meant to represent a particular segment of the market with the idea that it may be difficult, if not impossible, to outperform the market, given the costs associated with active management. While index bond funds are generally at a lower cost, the investor would do well to understand what index or indexes are being replicated. Certain government bond markets lack depth, which makes replicating them more difficult. In the world of index funds, the difference between a fund's performance and that of an index is known as a tracking error. In thinner, less liquid markets, this risk is more common and a concern.

The Bottom Line
The choice to invest in foreign government securities should be consistent with the investor's objectives and constraints. These may be governed by the type of account where the investment takes place. Foreign government bond funds holding credits of, say, emerging market governments, may warrant inclusion in retirement accounts with a longer time horizon. Additionally, the allocation to them should be modest, given the risks that they entail. For investors approaching retirement, foreign government bond funds may be appropriate, so long as consideration is given to more stable governments.

The approach to investing in foreign government bonds is no different from that of any other type of investment. The investor should understand why they want to purchase them, how much it costs to do so and if it is even feasible. Finally, the investment should fit with the investor's objectives and constraints.

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