Whether you recently became interested in international investing or are a seasoned global investor, a quick refresher course on foreign bond investing should help you assess your current strategy and future plans for the fixed income portion of your investment portfolio.

Q. What are the primary factors affecting returns on foreign bonds for U.S.-based investors?

A. Many factors are the same as for U.S. bonds: interest rate levels, credit market conditions, actual and expected inflation, and the pace of economic growth, to name just a few. Naturally, a bond's price also reflects its particular characteristics, such as credit quality and maturity, and also the supply and demand.

There are important differences between domestic and foreign bond investing that can increase overall risk. Many countries have less political stability and less diverse economies than the United States. Political or economic upheaval in such a country could jeopardize local bond markets, so the investor must continually monitor and interpret the internal developments of other countries. However, this risk can be greatly reduced by investing in government bonds of developed nations.

The aspect of foreign investing that probably generates the greatest day-to-day concern is the impact of currency translation. Initially, dollars must be converted to the local currency to purchase a foreign bond. Subsequently, price quotations, interest, and any sale or redemption proceeds must be converted from that foreign currency back into U.S. dollars. Because foreign exchange rates fluctuate constantly with changes in each currency's supply and demand situation, currency movements can increase or decrease the bond's dollar value (and investment return) even if its price remains unchanged.

Q. Given the added complexities, why invest abroad?

A. A principal advantage of investing overseas is diversification. A diversified portfolio gives you the opportunity to enhance your overall return while reducing risk. Interest rate movements in foreign bond markets frequently do not correlate with those in the U.S. While interest rates in one or more markets may at any time be moving in the same direction as U.S. rates, longer-term correlations are low. Additionally, since interest rate levels can vary widely from country to country, a diversified portfolio may also generate higher current income than one invested in bonds of a single country.

Another reason to invest overseas is the potential for higher total return. In any given year, some individual foreign bond markets are likely to outperform the U.S. bond market. Likewise, foreign bonds as a group may generate higher returns than U.S. bonds in some years, but not in others. On the other hand, if foreign bond markets underperform the U.S. bond market, diversifying overseas could reduce an investor's total return. In any case, a diversified portfolio should be cushioned from the full impact of potential losses when one market or the other has a down year.

The chart below shows 12-month results from foreign and U.S. government bonds in recent years. As you can see, performance leadership can vary from one period to the next. Over the 10-year period ending December 31, 1999, foreign bonds outperformed U.S. bonds on an average annualized basis (8.34% versus 7.81%). Of course, a portfolio manager may obtain significantly different results by investing in a mix of securities that differs from these indices.

Q. Can you show how currency translation alters local market returns to U.S. investors?

A. One way is to compare returns on a particular security, say German government bonds, to local investors and to U.S. investors during identical time periods. As the table shows, German bonds lost 1.8% for all of 1994, but a U.S. investor would have realized a solid 10% return on the same bonds because the deutschemark rose nearly 12% against the dollar. In 1996 and 1997, however, the deutschemark fell in value against the dollar, reducing returns to U.S. investors. In contrast, a weak dollar and strong German bond market performance in 1998 resulted in a gain of nearly 20% for U.S. investors. 

Source: Salomon Smith Barney

This chart is for illustrative purposes only and does not represent an investment in any T. Rowe Price fund. Past performance cannot guarantee future results.


Q. Is there any way to reduce the risk of unfavorable currency fluctuations? 
A. Yes. Portfolio managers may use sophisticated hedging techniques involving forward
exchange contracts or options to cushion the impact of potentially negative currency
movements. 

One type of hedge is called the direct hedge. For example, a U.S. investor buying a one-year Japanese bond may enter into a contract to exchange yen for dollars a year later at a price agreed upon when the contract is bought. This essentially eliminates changes in currency values as an unknown in the investment process. While it may protect against a currency-related loss, it also eliminates the possibility of gain from currency fluctuations. 

The other type of hedge is called the proxy hedge. Continuing the previous example, a U.S. investor using a proxy hedge would look for a currency that could be expected to move with the yen and, therefore, could serve as a "proxy" for the Japanese currency. While a proxy hedge can be more economical than a direct hedge, it is not risk-free because the proxy currency may not behave as expected. 

Mutual fund prospectuses spell out the types of hedges a fund can use, the expected
frequency of use, and the potential effects of hedging activity on a fund's total return. Since hedging costs are treated as capital transactions, they are not reflected in a fund's yield but rather in its net asset value.

Q. Should foreign investment decisions be based on the outlook for the exchange value of the dollar?
A. Currency translation can have considerable impact on performance, on the upside or the downside, especially in a fund with substantial unhedged assets. Over long time periods these effects tend to diminish. Investing in foreign bonds should be viewed primarily as a way to diversify fixed income investments as part of an overall strategy rather than as a "play" on the currency markets. Nevertheless, the impact of currency fluctuations must be taken into account when selecting foreign bond investments. Currency fluctuations should have less impact on a global fund holding U.S. dollar-denominated bonds than on a foreign bond fund without such bonds.

Q. How does an investor choose among the different types of overseas bond funds? 
A. There are three major decisions to make: 

1.between global and international funds, 
2.between short- and longer-term funds, and 
3.between funds investing in high-quality or lower-quality (high-yield) bonds. 

"Global" funds invest worldwide, including in the U.S., and thus should incur significantly less overall currency risk. "International" funds usually exclude U.S. investments except in the cash reserve position (typically under 10% of net assets). "World" funds may or may not invest in the U.S.; consult the prospectus. 

The short-term versus long-term decision should reflect your own objectives. As with all fixed income investments, foreign bonds with shorter maturities have less interest rate risk, meaning their prices fluctuate less than longer-term bonds in response to a given change in overall interest rate levels. 

The decision between a fund investing primarily in high-quality bonds and one
emphasizing lower-quality, high-yielding bonds depends on your desire for higher returns versus your tolerance for additional risk. As discussed below, bond funds investing in "emerging markets" offer the potential for significantly higher returns, but are more apt to sustain losses because of greater volatility. 

So if minimizing risk is an important objective, you should consider global bond funds with average maturities under five years. If you are willing to accept more day-to-day volatility in exchange for potentially higher returns over time, you may wish to investigate longer-term global or international bond funds, whose average maturities are usually five years or longer.  And if you want to take an aggressive risk/reward stance with a portion of your global bond investments, you could diversify into an emerging market bond fund. 

While you should always keep in mind the special risks of international investing, you should also consider its significant advantages. Diversifying internationally or globally can help smooth the fluctuations of your fixed income portfolio and can offer a way to take advantage of yields that may be higher than in the U.S. 

Investing in Emerging Market Bonds 

Q. What are emerging market bonds? 
A. Emerging market bonds are debt securities issued by governments and corporations of countries described as "less developed" or "developing" by organizations such as the World Bank. Developing countries have relatively low GNP per capita, and the credit quality of their bonds is usually, though not always, below investment grade, or "junk" in the U.S. market terminology. These bonds carry high yields to compensate investors for their additional risk.

Q. Are there different types of emerging market bonds? 
A. Yes. There are three main types: 

Local Bonds—Issued in local markets in local currencies, these usually offer the highest yields since they involve the greatest credit and currency risk and may be the least marketable. 

Eurobonds—Issued by developing countries in the London-based Eurobond market, these bonds may be denominated in any of several currencies, including U.S. dollars. 

Brady bonds—Named after a plan devised by former Treasury Secretary Nicholas Brady, these bonds are created when existing government or private debt is restructured and exchanged for new bonds, many of which are dollar-denominated and backed by U.S. Treasury zero coupon bonds. The backing generally assures the repayment of principal upon maturity, but does not apply to more than a few initial interest payments, if any. Although currency and credit risk may be reduced, most Brady bonds are still considered speculative investments. 

Emerging market bonds can reward investors with very high yields and possibly significant capital appreciation. Any favorable political or economic developments, including conversion into Brady bond status, that are expected to improve a bond's credit quality may send its price sharply higher.

Q. What are the risks of investing in emerging market bonds? 
A. Investing in such bonds involves substantially greater risk than investing in higher-quality foreign bonds. Prices of emerging market bonds can be severely affected not only by rising interest rates and adverse currency fluctuations, but also by the deterioration of credit quality or outright default by the issuer. Also, the low level of liquidity in emerging markets means that potential buyers may stay on the sidelines during unfavorable market conditions until bond prices are slashed. 

Q. What should I know about emerging market bond funds?
A. Mutual funds offer a convenient way for individuals to access the opportunities in many developing markets. Funds are, in fact, the single largest source of demand for emerging market bonds, so their cash inflows and outflows can increase the market's volatility.

However, not all emerging market bond funds are alike: some emphasize yield, some appreciation, some both equally. Portfolio asset allocations can also vary significantly, resulting in different risk profiles. If you can ride out price declines to pursue the potential of this bond market frontier, be sure to select a fund whose objectives and program are appropriate for your risk tolerance and investment time horizon. 


The Euro

On January 1, 1999, several major European countries adopted the euro as a single European currency backed by the European Central Bank. The currencies of the participating countries have become fixed rate units of the euro, much the same as the nickel, dime, quarter, and half-dollar are denominations of the U.S. dollar. The initial participating countries are Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain. 

At the outset, some European securities were redenominated in euros, particularly government securities. The face value of other investments might remain in the existing national currencies for a time, but they will be valued in euros by stock exchanges and other agencies. This should not affect the investment values of U.S. mutual funds that invest in Europe, since the euro is convertible into the dollar. Assuming all goes well, the national currencies of participating countries will cease to exist by June 30, 2002, and all accounting thereafter will be in euros. 

Learn more about T. Rowe Price & Associates

Previous Page

Back to Fund Focus Main

Next Page