International Bonds

International bonds are fixed-income securities issued by foreign national governments, their agencies and local governments, supranational lenders, and non-U.S. companies, as owned by an investor based in the United States. They span developed markets, such as Japan, Germany or Canada, and emerging markets, and they may be denominated in the issuer's own currency or in U.S. dollars. Individuals can hold them directly or through an international bond mutual fund or exchange-traded fund. A fund described as a "global" bond fund may hold U.S. bonds as well, so the label is worth checking against the fund's holdings.

Two returns in one holding. A U.S. investor in a bond that pays in euros or yen earns the bond's return in that currency, then converts it back to dollars at whatever exchange rate prevails. The SEC's investor guidance on international investing makes the general point: when the exchange rate between the dollar and an investment's currency changes, "it can increase or reduce your investment return." For stocks, currency is one influence among many. For high-quality bonds, whose prices usually move far less than stock prices, the currency can become the dominant influence.

Why hedging matters more for bonds than for stocks. A study published by the Federal Reserve Board in 2004 put it directly: "Returns on unhedged developed country bonds are very volatile because exchange rates are volatile." Comparing hedged and unhedged returns on developed-country bonds in the years to December 2001, the authors found "unhedged returns are much more volatile than hedged returns, on average by a factor of eight," and judged that finding not to depend on the period, even though the higher return of the hedged portfolio did. The factor of eight compares the variance of returns, the statistic the paper's table reports; in standard-deviation terms, the more familiar measure of volatility, the gap is closer to threefold. A currency-hedged fund uses forward contracts or similar instruments to offset exchange-rate moves, so its result tracks the bonds' local-currency performance. The hedge has costs, and it gives up the gain when the foreign currency strengthens against the dollar. An unhedged fund is in effect a bond holding plus a currency position.

Developed and emerging markets differ. The same Federal Reserve study found that emerging-market bonds "exhibit sizeable volatility" and the most negative skewness of the groups it examined, because periods of poor bond performance in those markets tended to coincide with capital leaving the country rather than with the currency rising. An emerging-market bond issued in U.S. dollars removes the direct currency effect for a U.S. investor but leaves the borrower's credit risk, so a fund's mix of dollar and local-currency bonds changes what it is exposed to. The SEC also lists risks that apply to investing abroad generally: currency controls that can delay moving money out of a country, political and economic events, lower liquidity and different market practices.

Where they sit in a portfolio. A typical U.S. total bond market fund holds U.S. Treasury bonds, mortgage-backed securities and investment-grade corporate bonds and leaves most international bonds out, so an investor who wants them adds a separate fund. The usual argument for doing so is diversification: interest rates and credit conditions in other countries do not move in lockstep with those in the United States. Whether that benefit is worth the added complexity, cost and currency decision is a judgment, not a rule; the three-fund portfolio leaves international bonds out, and its four-fund variant adds them.

The return to a U.S. investor from an unhedged foreign-currency bond is roughly the bond's local return combined with the change in the value of the currency against the dollar. Multiplying (1 + the local return) by (1 + the currency change) and subtracting 1 gives the combined result.

Take an example with assumed figures. A fund holds bonds that return 3% over a year in their own currency. If that currency falls 8% against the dollar, the unhedged result is 1.03 × 0.92 − 1, or about −5.2%, a loss despite positive bond returns. If the currency instead rises 8%, the result is 1.03 × 1.08 − 1, or about +11.2%. A fully hedged version of the same fund would have earned close to the 3% local return in both cases, adjusted by the cost or benefit of the hedge. The bonds were identical in all three cases; only the currency decision changed the outcome.

Pros

• Adds exposure to interest rates and credit markets outside the United States, which do not move in step with U.S. markets.
• A hedged fund can offer that diversification while keeping volatility close to that of the underlying bonds.
• Reaches the bonds of foreign governments and companies, which a U.S.-only bond fund leaves out.

Cons

• Unhedged holdings can swing far more than the bonds themselves because of exchange rates.
• Hedging has costs and forgoes gains when foreign currencies strengthen.
• Emerging-market bonds add credit, political and liquidity risks, with a tendency toward sharp losses in crises.
• A separate fund adds cost and another decision, and its expense ratio may exceed that of a broad U.S. bond index fund.