Investors often include foreigners or international bonds in their portfolios for a few main reasons – to take advantage of higher interest rates or yields and to diversify their holdings. However, the higher return expected from investing in foreign bonds comes with increased risk arising from currency fluctuations.

Due to the relatively lower levels of absolute returns from bonds compared to stocks, currency volatility can have a significant impact on bond returns. Therefore, investors should be aware of the exchange risk that comes with foreign bonds and put measures in place to mitigate the currency risk.

Currency risk and foreign bonds

Currency risk does not only arise from holding a foreign currency bond issued by an overseas entity. It exists whenever an investor holds a bond that is denominated in a currency other than the investor’s home currency, regardless of whether issuer is a local institution or a foreign entity.

Multinational companies and governments commonly issue bonds denominated in different currencies to benefit from lower borrowing costs and also to match their foreign exchange inflows and outflows.

These bonds can be broadly classified as follows:

• A foreign obligation is a bond issued by a foreign company or institution in a country other than its own, denominated in the currency of the country in which the bond is issued. For example, if a British company issued a bond in US dollars in the US
• A Eurobonds is a bond issued by a company outside its domestic market, denominated in a currency other than that of the country in which the bond is issued. For example, if a British company issued a US dollar bond in Japan. Note that “Eurobond” does not refer to bonds issued only in Europe, but rather is a generic term that applies to any bond issued without a specific jurisdiction. Eurobonds are named after their currency of denomination. For example, eurodollar bonds refer to USD-denominated Eurobonds, while Euroyen bonds refers to bonds denominated in Japanese yen.
• A foreign payment bond is a bond issued by a local company in its home country that is denominated in a foreign currency. For example, a Canadian dollar bond issued by IBM in the United States would be a foreign-payable bond.

Currency risk results from the bond’s denominated currency and the location of the investor, rather than from home of the issuer. A US investor holding a yen bond issued by Toyota Motor is obviously exposed to currency risk. But what if the investor also owns a Canadian dollar bond issued by IBM in the US? Currency risk exists in this case as well, even though IBM is a national company.

However, if an American investor owns a so-called “The Yankee Connection” or a Eurodollar bond issued by Toyota Motor, exchange risk does not exist despite the fact that the issuer is a foreign entity.

How currency fluctuations affect total returns

A slippage in the currency in which your bond is denominated. will decrease total returns. Conversely, an appreciation of the currency will further enhance the return from holding the bond – the icing on the cake, so to speak.

Consider an American investor who purchased €10,000 nominal value of a one-year bond with an annual coupon of three percent and trading to para. The Euro was flying high at the time, with an exchange rate against the US dollar of 1.45, meaning 1 EUR = 1.45 USD. As a result, the investor paid $14,500 for the Euro bond. Unfortunately, by the time the bond matured a year later, the euro had fallen to 1.25 against the US dollar. Therefore, the investor received only $12,500 upon conversion of the maturity proceeds of the euro-denominated bond. In this case, the currency fluctuation resulted in a foreign exchange loss of $2,000.

The investor may have originally bought the bond because it was yielding three percent, while comparable one-year U.S. bonds yield only one percent. The investor may also have assumed that the exchange rate would remain relatively stable over the one-year term of the bond. holding period.

In this case, the two percent positive yield difference offered by the Euro bond did not justify the currency risk assumed by the American investor. While the foreign exchange loss of $2,000 would be offset to a limited extent by coupon payment of EUR 300 (assuming an interest payment made at maturity), the net loss of this investment still amounts to $1,625 (€300 = $375). This equates to a loss of approximately 11.2% of the initial investment of $14,500.

Of course, the euro might as well have gone the other way. If it had appreciated to 1.50 against the US dollar, the gain from the favorable currency movement would have been $500. Including the €300 or $450 coupon payment, the total returns would have amounted to 6.55% of the initial investment of $14,500.

Hedging currency risk in bond holdings

Many international fund managers hedge currency risk rather than the risk of returns being decimated by adverse currency fluctuations. However, the coverage itself carries a degree of risk because there is a cost attached to it. Because the cost of hedging currency risk is largely based on interest rate differentials, it can offset a substantial portion of the higher interest rate offered by foreign currency bonds, thus undermining the rationale for investing in such a bond in the first place. Depending on the hedging method used, the investor may be locked into a rate even if the foreign currency appreciates and bearing a opportunity cost as a result.

In a number of cases, however, the coverage can be well worth it either to lock in foreign exchange gains or to protect against currency slippage. The most common methods used to hedge currency risk are: currency forward and futures, or currency options. Each coverage method has distinct advantages and disadvantages. Currency forwards can be adjusted to a specific amount and maturity but lock in a fixed rate, while currency futures offer high leverage but are only available in fixed contract sizes and maturities. Currency options offer more flexibility than forwards and futures, but can be quite expensive.

conclusion

Foreign bonds can offer higher returns than domestic bonds and can diversify the portfolio. However, these benefits should be weighed against the risk of loss from adverse exchange rate movements, which can have a significant negative impact on the total return of foreign bonds.