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Foreign Bonds: Your AAA Way to Security, Income and All the Power of Foreign Currencies in a Single Investment
By The World Currency Watch Research Team These days, there are many interesting opportunities for investing in foreign currencies, from longterm currency ETFs to short-term Forex trades. In fact, there are so many ways to invest in foreign currencies that its easy to forget one of the safest, long-term strategies: The foreign currency bond. Few currency investments offer you the security and long-term income potential of a foreign currency bond. These widely available foreign investment opportunities are easy to buy, incredibly liquid, and theyre even relatively easy to predict compared to other assets. Some even protect you against currency risk. Best of all, these bonds are often at their best when an economy is headed for a downturn, making them a perfect investment for todays turbulent economic outlook. What is a Foreign Currency Bond? In short, a foreign bond is any government-issued debt, in its local currency. However, any bond available on your own domestic markets denominated in a foreign currency also falls into this category. Since the first foreign currency bonds were issued in the mid 1950s, the rapid development of the world bond market has allowed issuers to raise capital outside of their own domestic markets while providing a wealth of opportunities to the average investor. As you probably know, a bond is one of the most basic, cut-and-dried investments in the markets. Its simply a loan with interest. Only instead of taking out a loan yourself, youre loaning your assets to either a company or country that has to pay you back with interest when your bond matures. You essentially become the creditor, instead of the borrower. When you purchase a bond, it has a maturity date and a coupon rate. After you buy the bond, youre paid the coupon rate (a percentage of what you originally paid for the bond) annually on specific coupon dates. Usually these payments come twice a year. Once your bond matures, you are repaid the bonds principal or the face value and the transaction is over. This is a very general example, but it demonstrates the fundamentals of bond investing. So for instance, say you bought a three-year Treasury note in the United States at the most recent rates. At best, you would make between 23% annual yield on your investment. So twice a year on your coupon date you would receive a 1% to 1.5% return. Not bad 1

right? Well, in a year when annual inflation is expected to hit the neighborhood of 5%, a paltry 2% to 3% wont help you build up your portfolio. In fact, at these rates, you would produce a negative yield and lose 2-3% of your original investment value. But thats why foreign bonds are such a profitable alternative. Foreign bonds allow you to capitalize on the global economic climate and maximize the value of your bond investments. If you bought that same three-year bond in another country, you can secure an even higher coupon rate (as high as 3% to 4% depending on the country). Plus, you can earn extra profits from any currency appreciation of the local currency rising against the U.S. dollar. Lets look at an example. Riding High on the Australian Dollar In August 2008 a three-year Australian bond yielded 5%. Lets assume you invested $5,000 U.S. dollars in this three-year bond. To invest in an Australian dollar bond, you first need to call your broker. Most brokers can handle foreign bonds, but make sure to ask about fees, etc. The next thing you need is the local currency. So your broker will convert your U.S. dollars into Australian dollars. Lets say the exchange rate on AUD/USD is $0.86. (That means you get one Australian dollar for every US$0.86.) To find out how much youre paying (in Australian dollars), simply divide 5,000 by 0.86 = A$5,813.95. **Its important at this point to note the difference in coupon dates on foreign and domestic bonds. While many American bonds split their coupon payment between two dates over the course of the year, most foreign bonds pay their coupon all at once, on a single coupon date. Be sure to account for this minor difference when deciding where and how much youll invest.** At your request, your broker will invest in a bond paying a set interest rate for a set term it could be one, three, or five years, for example: Say you decided to buy a three-year Australian bond that pays 5%. Then after three years, you decide to sell your mature bond. If the Australian dollar has risen in value versus the U.S. dollar, you would gain extra profits on the appreciation. Lets just say the exchange rate has jumped to .96 for every one U.S. dollar. So the U.S. dollar is now worth .96 Aussie cents, you receive your initial A$5,813.95 x .96 = US$5.581.39. Thats an extra US$580 just from currency appreciation alonenot counting your yield. In essence, you earned profits twiceif the Australian dollar appreciates against the U.S. dollar.

Keep an Eye on the Yields I mentioned earlier that bond performance is relatively easy to predict. Though its almost impossible to predict the performance of some of your more volatile investments, bond performance generally remains stable and consistent in the long-run. And the yield curve is your key to understanding and predicting bond returns. A Sample Yield Curve for T-Bills

A yield curve is a chart displaying the relationship between interest rates and maturity dates of bonds with similar credit quality. The yield curve helps forecast what economic activity will affect your bonds price going forward. Foreign bonds are all priced based on their yield to maturity percentages. Therefore, as a bond yield goes up, the bond price goes down, and vice versa. Brazils Yield Curve Tells All

Its important to look at the yield curve, because you can discover a lower-yielding short-term bond may actually pay more than a higher-yielding longer-term bond once you factor in inflation. Take a look at the graph above. Note that the three month yield is slightly higher than the one year yield! As you can see, there is no incentive outside of currency appreciation to go with the longer-term choice. In fact, if youre bearish on the Brazilian real or you expect inflation, you may find that the returns would be substantially better with the short-term bond.
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Tips for Buying Bonds Search for bonds in a country thats experiencing rate cuts, a slower economy and other bad news or data. Be sure to buy the highest quality AAA Sovereign bonds because they have the lowest risk of default. You want to buy bonds in a local market when a countrys economy has peaked and will slow down for a period of time going forward. If you buy a foreign bond just before the economy slows down, then you essentially lock in your yield to maturity. As the economy in the country slows, the interest rates drop making your higher yielding bonds more expensive, or valuable to the holder. You can then decide to sell your foreign bonds at a profit, or continue to hold your higher yield bond to maturity. Most foreign bonds sell in $1,000 increments with minimums much larger in different markets. A Note on Currency Risk and How to Protect your Investment Currency risk is defined as how your investments value can fluctuate based on changes in that currencys exchange rate. In this case, its the risk that the currency your bond is denominated in will lose value against the dollar. Currency risk can affect any of your foreign-currency based investments, and its something you should always consider when investing abroad. Even though the dollar is on a steady decline and its a great time to diversify your holdings, you will always run the risk that your foreign currency-based investments can actually depreciate in value over time. However, some foreign currency bonds can actually protect you from this risk in the short-term. Some banks and brokerages will allow you to purchase a foreign bond, and then sell or receive interest in the foreign currency. But then you can convert both your principal and your interest back to dollars when its most advantageous for you to do so. For example, lets say that your euro-based bond reached maturity in August of 2008 (the area circled in red on the chart below). Unfortunately at the same time the dollar was making its biggest rally against the euro to date.

Currency Risk Averted, Profits Preserved

If youre confident in the long-term potential of the euro, then you can hold the principal and interest from your bond in euro until the exchange rate is more favorable. In other words, wait for the euro for rise again, and then convert your profits back when youll get the best return. When the dollar bear market resumes which we think it will go into the later half of 2009the fundamentals will trump the fear and the euro should benefit at the dollars expense. Be sure to discuss this characteristic with your broker before buying so that you can hedge against currency risk. The Best Foreign Bond to Buy This Year Right now, the best bonds to buy are located in Norway. A country with only 4.7 million people, Norways primary exports come from natural resources, including oil exploration and exports, fisheries and hydroelectric power generation. Over the last few years, the clever Norwegians have developed an excellent model to carefully and strategically manage revenue form these exports. They have transformed oil revenue into a national social fund for the whole country. Their stringent fiscal management allows them to navigate the booms and bust cycles of oil prices successfully. Because of this importance of oil exports, the Norwegian krones value tends to follow the price of oil. And in the next few years we expect oil prices to rise. Heres why The massive U.S. deficits will continue to push downward pressure in the U.S. dollar. As you know, oil is priced in dollars all over the world. So a cheaper dollar will force oils price higher. But we are also a strong believer of the Peak Oil theory. As the Asian economies pick up speed in their growth rates in the coming months, demand will really ramp up, and the shortage on the supply side will become apparent. At the same time, production is declining in most major oil-producing countries in the world. The
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worldwide demand for oil will simply outstrip supply, pushing prices of oil up. The Norwegian krone will be a big beneficiary of that trend. So here are two top credit quality Norwegian bonds: Norwegian Rabobank with a coupon of 4.25%, maturing in 9/2/2014 (ISIN XS0448022102). If youre looking for something with a shorter maturity, you can buy KSW bond paying a 3% coupon and maturing in 3/23/2012 (ISIN XS0418291174). Both are government guaranteed bonds rated AAA and denominated in Norwegian krone. A bond is one of the most basic, cut-and-dried investments in the markets. But by investing in foreign bonds, you can enjoy fixed income and extra currency appreciation if the local currency rises versus the dollar. Add in the fact that these bonds are highly-rated and government-backed, and youve got a long-term, safe way to cash in on some of the most profitable foreign currencies around the world.