When it comes to investing in bonds, there is a world of opportunity beyond the U.S. fixed income markets. In fact, according to the Securities Industry and Financial Markets Association, the size of the global bond market in 2006 was estimated at $45 trillion, a little over half of which was U.S. issuances.

Much like the international equity markets, investing in international bonds offers a myriad of potential benefits, including higher returns and diversification possibilities for your investment portfolio. In this article, we'll compare the international debt markets to the U.S. fixed income markets and examine the how and why of investing in international debt. We'll also will assess the risks involved in global bonds, how portfolio managers may hedge those risks and which international fixed-income investment vehicle may be right for your portfolio.

Foreign Bonds
Foreign bonds are issued by governments or corporations located outside of one's domestic market and trade on foreign financial markets. Also, as one may expect, these bonds most often trade in the currencies of their domestic markets. For example, a bond issued by a Japanese bank in the Japanese market paying interest in Japanese yen would be a foreign bond to U.S. investors.

There is little structural difference between bonds issued in foreign markets and those issued domestically, as they both pay regular streams of interest and repay the principal at maturity.

Why invest in international bonds?
The main benefits of investing in international bonds include portfolio diversification, higher historical returns and currency benefits.

  1. Diversification
    International debt offers significant portfolio diversification, going beyond a portfolio consisting solely of U.S. government and corporate debt, which often move in a similar manner to U.S.-specific events. For example, U.S. bond investors, whether invested in corporate or Treasury bonds, will be hurt if interest rates rise as the prices of their bonds fall. (For more insight, see Advanced Bond Concepts: Term Structure Of Interest Rates.) However, if your bond investments are spread over different countries, you will diversify your portfolio and, in theory, lower your overall risk. This is because an investment in Japanese corporate bonds or European Union issues won't be affected to the same degree by shifts in U.S. interest rates as U.S. bonds. (For related reading, see Going International.)
  2. Higher Historical Return
    In addition, historical returns have shown that global fixed-income investments tend to have a higher rate of return than U.S. debt securities. According to Citigroup, when comparing hedged global bond indexes to U.S. Treasury returns, between 1991 and 2007 the global bond indexes generated an annualized return of around 7% versus the 6% return that U.S. Treasuries returned over the same period. (For related reading, check out The Bond Market: A Look Back.) There are several reasons that one might expect higher returns. These include greater risks as well as a less competitive marketplace.
  1. Currency Hedge
    Foreign bonds are a natural hedge on the U.S. currency as the interest payments and principal are made in the foreign currency. If the U.S. currency falls in relation to the currency paid on the foreign bond, the bond investor will gain as the foreign currency will convert into a greater amount of U.S. dollars. (For background reading, check out A Beginner's Guide To Hedging.)

The Role of Risk in Foreign Bonds
Despite the benefits, there are risks to investing in foreign bonds. Foreign bonds, while they offer diversification opportunities, can also carry considerable risk. Currency and default risks are the predominant concerns here.

  1. Currency Risk
    While investing in foreign bonds does provide a natural hedge on the U.S. dollar, the flip side to this is the risk that the U.S. dollar moves strongly against the denominated currency of the bond. A strong move by the U.S. dollar against the foreign currency would reduce the effective interest/principal payment you would receive after conversion. As such, it is important when investing in foreign bonds to understand this risk and evaluate the likely move of the relevant currencies before purchase.
  2. Default Risk
    Default risk is of particular concern for foreign bonds that are issued in less industrialized countries or nations where there is considerable political strife. Under these conditions, interest rates and monetary policy can fluctuate more widely than in more established countries. In addition, there have been historical examples of sovereign nations defaulting on their sovereign debt or severely devaluing it. These factors create a complex environment that is often best left to professional investors. For example, the Russian default in 1998 or the Asian financial crisis in 1997 illustrate situations where international bond investors could have been hurt.

    Hedging Global Bond Risk
    There are hedging techniques that some fund managers employ to reduce the risk of the global bonds. One of the most common of these strategies is hedging inherent currency risk by using futures contracts or buying positions in foreign exchange markets in order to counteract interest rate swings that impact currency values. (For further reading, check out Futures Fundamentals.)

    While global bonds tend to be denominated in the currency of the country in which they are issued, there are exceptions. The two most notable of these exceptions are Brady bonds and Yankee bonds, both of which are sold in U.S. dollars. With the primary exception of Brady bonds, which are backed by the U.S. Treasury, most global bonds have higher default and currency risks than U.S. bond issues. This means that, similar to U.S. Treasuries, the American government guarantees the bond payments of those issues. Some feel that Brady bonds offer the best of both worlds in that they offer the diversification of exposure to other countries while being backed by the U.S. government.

    How to Invest in Global Bonds

    Due to multiple levels of risk, investing in global bonds is often best left to a portfolio manager. Even if an individual investor studies global fixed income, most international bond issues are difficult to purchase directly from the sovereign government or offshore corporation that issues them.

    Also, in some cases foreign governments don't allow the purchase of government bonds by non-residents.

    Most major investment houses have at least one fund that specifically invests in global bonds, so you should be able to easily find an international bond fund that will give you some exposure to this market. Gaining exposure to international fixed-income issues through this means should diminish some of the risk inherent in investing in global debt. (For more on bond funds, see Evaluating Bond Funds: Keeping It Simple.)

    Discuss What Is Best for Your Needs
    Ultimately, international fixed income is a complex investment vehicle, and most investors would be best served by discussing the range of options with their investment advisor. Give some thought as to what kind of risks you are willing to take, given the balance of your other investments and - together with your advisor - consider exploring the wide world of global bonds. The risk may be worth the reward.