Investing in foreign bonds

Key Points

• Basics of Foreign Bonds
• Mutual Funds Investing in Foreign Bonds
• Diversification Benefits
• Considerations Before You Go Global
• Factors Affecting Foreign Bond Prices
• Explore the Possibilities
• Points to Remember

In recent years U.S. investors have displayed their interest in opportunities beyond our shores by investing increasingly in foreign securities. Are you ready to venture into foreign lands for fixed-income investments? Before you decide, take a few moments to learn about them and then consult your professional financial planner.

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Basics of Foreign Bonds

Like domestic bonds, foreign bonds represent a financial obligation of a government body or corporation. The issuer promises to pay the buyer a specific amount, either through interest payments and/or a lump-sum payment at maturity. In exchange, the buyer essentially loans the issuer the principal amount for its use. In other words, a bond is an "IOU."

There are two options for investing in foreign bonds — you can purchase individual issues or shares of mutual funds that invest in foreign bonds. Historically, it was difficult to purchase individual bonds. Companies that sold them often had minimum investments of $100,000 or more for retail investors. But in recent years, it has become more common for bonds to be available for as little as $5,000.

Nonetheless, mutual funds remain the preferred vehicle for investing in foreign bonds. They generally offer a more affordable opportunity to invest in a mix of foreign bonds than purchasing them separately. Should you decide to invest in foreign bonds through a mutual fund, you'll find a variety of funds from which to select:

• Emerging-market funds invest in debt issues of developing countries in regions including Southeast Asia and Eastern Europe. These tend to involve greater volatility and greater return potential.
• International bond funds invest predominantly in the debt of developed countries outside the United States, but U.S. bonds may comprise up to 25% of the holdings.
• Global bond funds also invest in the debt of developed nations, but generally have more than 25% of their assets invested domestically.

You can also find mutual funds that invest only in specific regions of the world, such as the Pacific Rim or Europe, and in select countries. In addition, mutual funds are often able to invest in countries whose markets are closed to individual investors who are noncitizens.

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Mutual Funds Investing in Foreign Bonds

• Emerging-Market Funds
• International Bond Funds
• Global Bond Funds

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Diversification Benefits

Why would you invest in the debt of a country half way around the globe when there are many debt issues right at home? Diversification is one good reason. Holding foreign bonds or shares of foreign bond mutual funds, in addition to U.S. debt issues, may help you to reduce the risk of price fluctuations and potentially increase earnings. According to a study by Standard & Poor's, investors who invested up to 50% of their fixed-income allocation in foreign bonds generally realized slightly higher returns than investors who invest solely in U.S. bonds, with very little increase in risk.¹ The reason: When the American market is on its way down, other overseas markets may be on their way up.

While the U.S. and foreign bond markets have not consistently moved in sync in the past, you should be aware of a developing trend. In recent years, as international agreements have begun to knock down trade barriers and we have approached a more global economy, the correlation between the American and foreign bond markets has decreased. From 1985 through 1997, the correlation between international bonds and U.S. bonds was 0.30, according to Standard & Poor's.

Between 1998 and 2008, the correlation rose to 0.55.¹ The closer the correlation moves to 1, the greater the likelihood that the U.S. and foreign markets will move in tandem.

Remember, too, that as much as one-quarter of the holdings of a global bond fund may consist of U.S. bonds, potentially increasing the correlation between the American market and foreign markets.

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Considerations Before You Go Global

The key factor to be aware of when considering foreign bonds is the role of currency rates. Changes in the value of a foreign country's currency can directly impact the value of bonds issued from the country. For example, if the value of a foreign country's currency rises relative to the U.S. dollar, the earnings from bonds issued there will buy more dollars when received by the investor. There are a number of factors that affect a nation's currency, including:

• Interest rates — Higher rates could lead to an economic slowdown and, thus, less demand for the currency. Lower rates, on the other hand, could create demand for currency.
• Direct and indirect investment — When companies within a country or investors from abroad foresee economic growth and invest by building factories or purchasing equities, demand for the currency grows.
• Trade flows — The more a country's exports grow and exceed the level of imports, the greater the demand for the currency.
• Inflation — As prices rise, the value of a nation's currency declines.

Many mutual funds seek to hedge against the impact of currency fluctuations. For example, a fund could hedge by purchasing a forward currency contract, which promises to pay a set exchange rate for holdings in the fund by a specific date. However, depending on which way a currency moves, such a strategy could end up costing the investor just as easily as it could offer protection. Another strategy some funds implement is to invest in foreign bonds denominated in U.S. dollars, which can minimize currency fluctuation concerns.

In addition to currency rates, the credit quality of a nation's bond investments should not be overlooked. Credit quality in developing nations, for instance, may be affected by their more volatile political or economic atmospheres. In addition, such countries may not adhere to the same standards of accounting and oversight required in the U.S. and other developed countries. Fortunately, as developing countries join in the global economy and require foreign capital to grow, they are more likely to implement such standards to encourage investment.

Factors Affecting Foreign Bond Prices

• Interest Rates
• Currency Exchange Rates
• Credit Quality
• Tax Laws

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Explore the Possibilities

Foreign bonds are not for every investor. They can be complex instruments and may entail greater volatility than U.S. fixed-income investments. But with professional assistance, you may find that foreign bonds can add an appealing international flavor to your portfolio.

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Points to Remember

1. There are several types of mutual funds that invest in foreign bonds, including international funds, global funds and emerging-market funds.
2. Foreign bonds can reduce risk in a fixed-income portfolio through diversification.
3. The correlation between the U.S. bond market and foreign markets has increased in recent years.
4. Holding up to 50% of a fixed-income portfolio in foreign bonds can reduce risk and increase returns.
5. Factors that affect currency rates include interest rates, direct and indirect investment, trade flows and inflation.

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¹Source: Standard & Poor's, 2008. Performance is for the period January 1, 1985, to December 31, 2008. Assumes a 60/40 allocation between stocks and bonds. Stocks are represented by the S&P 500 index. U.S. Bonds are represented by the Citigroup Broad Investment Grade Bond index. Foreign bonds are represented by the Citigroup Non-U.S. Dollar World Government Bond index. Investors in international securities may be subject to somewhat higher taxation and higher currency risk, as well as less liquidity, compared with investors in domestic securities. Past performance is not a guarantee of future results. Index results do not take into account the fees and expenses associated with purchasing individual securities or fund shares, and individuals cannot invest directly in an index.

Financial planning services and investments offered through Ameriprise Financial Services, Inc., Member FINRA and SIPC.

There are risks associated with fixed income investments, including credit risk, interest rate risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer-term securities. Non-investment grade securities, commonly called "high-yield" or "junk" bonds, generally have more volatile prices and carry more risk to principal and income than investment grade securities.

International investing involves increased risk and volatility due to potential political and economic instability, currency fluctuations, and differences in financial reporting and accounting standards and oversight. Risks are particularly significant in emerging markets.

Diversification helps you spread risk throughout your portfolio, so that investments that do poorly may be balanced by others that do relatively better. Diversification is not a guarantee of overall portfolio profit or protection against loss.

Investment products, including shares of mutual funds, are not federally or FDIC-insured, are not deposits or obligations of, or guaranteed by any financial institution, and involve investment risks including possible loss of principal and fluctuation in value.