Reader Sam asked me if I could write a post about buying foreign government bonds as a way of diversifying your portfolio. The idea of buying foreign government bonds is appealing on several levels because you get to invest in a foreign currency, you get a regular coupon, and it definitely diversifies your portfolio.
I don’t foresee myself investing in foreign government bonds. With so many risk factors at play, I think I’d much rather invest in equities if I were to go international. Bonds should be used as a “safer” investment and when you go international, you introduce so many risks that cut into the idea that bonds are a safe investment.
That being said, it’s still important to understand how things work and if you want to buy foreign government bonds, here’s how.
Risks of Foreign Government Bonds
What are the risks? There are many. First, you have to deal with currency risk. Since you’ll be buying foreign government bonds with foreign currency, you’ll be affected by the fluctuations in the exchange rate. If the dollar becomes more valuable, your investment loses value in dollar terms. If the dollar gets weaker, your investment gains value in dollar terms. If you haven’t been keeping up with the performance of the dollar, you might be aware at how volatile it can be. While it’s valuable to diversify, be sure you’re aware of how much this diversification might cost you in the way of risk.
Second, buying foreign government bonds subjects you to country risk. Unlike in the United States, it’s not as uncommon for foreign government to default on their debts. If you remember the last time we had a financial crisis, in the 90’s, you might recall that it was started when Russia “defaulted” on its bonds (technically, they devalued the ruble and declared a moratorium on about $13.5b of its debt). In the 1980’s, you may remember Mexico defaulting on its debt as well (August 1982). It doesn’t happen often, but it’s happened more often than you’re probably comfortable with. If you are aware of this and can accept it, then buying a foreign government bond might make sense for you.
How to Buy Foreign Government Bonds
The easiest way is to purchase these bonds by way of a mutual fund. Morningstar offers the following 25 World bond funds , ranked by 3 year performance. There are significant advantages when you buy shares of a mutual fund, rather than the bond itself. You get diversification across several bonds and countries, thus reducing your risk of a single country defaulting. You also get access to a more liquid market, selling shares of a mutual fund is much easier than selling an actual bond. Finally, you don’t have to worry about foreign exchange headaches when it comes to actually buying the bonds.
If bond funds don’t interest you and you want to purchase individual foreign government bonds, ask your current stock broker if they offer foreign government bonds. You might be able to purchase them through your broker and save yourself some time. The cheapest route will always be to purchase the bonds directly from the government, through whatever auction system they have, but using your broker can cut through some of the red tape and reduce your headaches.