What to Know Before Trading or Investing in Foreign Bonds
Foreign bonds are instruments that are much more complex to trade or invest in than domestic bonds.
There’s a lot to them that doesn’t meet the eye at first.
For example, when amateur traders and investors decide to buy a foreign bond, what’s going to be the one thing they hyper-focus on?
The nominal yield.
However, to say that there’s more to this would be an understatement.
A multitude of factors can influence the outcome, making it a challenging task even for highly experienced and well-trained professionals.
Here are the numerous elements that come into play beyond just the nominal returns.
Inflation can erode the real value of a bond’s returns, making the investment less profitable than initially anticipated.
Everything always has to be judged in real (inflation-adjusted) terms, not nominal.
This goes for your assets, income, expenses, and liabilities.
Different countries have varying tax regulations, which can significantly impact the net return on investment from foreign bonds.
Differential Tax Treatment
Different countries may have varying tax treatments for foreign investments, affecting the net returns for investors.
If you own a foreign bond, can you be double taxed?
Yes, if you own foreign bonds, you can be double taxed: once in the bond’s issuing country and again in your home country.
However, tax treaties may provide relief from such double taxation.
Foreign Exchange Risk
Investing in foreign bonds exposes investors to the risk of currency value fluctuations, which can adversely affect the investment’s value and returns.
For example, if I’m a US-based trader and I put my money into a Canadian bond denominated in CAD, I’m now exposed to USD/CAD exchange rate movements.
Many traders hedge the FX risk, which is a different topic.
(This is less of an issue for traders/investors who don’t care about any prospective mark-to-market losses, can withstand the fluctuations, have them in a “hold-to-maturity” portfolio, and the issuer doesn’t default.)
Credit risk is the risk that the bond issuer will default on their debt obligations, resulting in a loss for the bondholder.
Liquidity risk arises when an investor is unable to quickly sell the bond at a fair price, leading to potential losses.
Changes in regulations can affect the bond market, impacting the value and profitability of foreign bonds.
Reinvestment risk is the risk that the investor will have to reinvest the bond’s cash flows at a lower rate than the original bond.
Call and Prepayment Risk
This risk involves the possibility that a bond will be called or prepaid by the issuer before its maturity date, potentially leading to lower returns for the investor.
Sovereign risk refers to the risk that a government will default on its debt obligations.
This can impact the value and returns of other assets.
Certain countries impose capital controls that can affect the movement of assets, impacting the liquidity and value of foreign bonds.
Structural Features of the Bond
The specific structural features of a bond, such as its terms and conditions, can influence its risk and return profile.
Settlement and Operational Risks
Operational inefficiencies and settlement issues can lead to delays and losses for bond investors.
Changes in bond benchmarks can impact the relative value and performance of a bond.
Flows and Positioning
Market flows and positioning (i.e., speculative flows, “sentiment”) can influence bond prices and returns, affecting the investment’s performance.
Unexpected events can have a significant impact on the bond market, leading to potential losses.
Legal and Contractual Protections
The level of legal and contractual protections for bondholders can influence the risk profile of a bond investment.
Broker and Intermediary Costs
Costs associated with brokers and intermediaries can erode the returns on a bond investment.
This is not just trade fees, but also the spread you have to pay to get in and out of a trade.
Relative Value Considerations
Assessing the relative value of a bond in comparison to other investments is imperative for making good decisions.
Rating Agency Assessments
Rating agencies assess the creditworthiness of bonds, and their assessments can impact bond prices and investor confidence.
Debt Maturity Profiles
The maturity profile of a bond can influence its risk and return characteristics, affecting its suitability for different traders/investors.
Transparency and Reporting Standards
The transparency and reporting standards of a bond issuer can impact investor confidence and the bond’s market performance.
Political instability in the bond issuer’s country can negatively impact the investment, leading to potential default or other adverse outcomes.
Various Tail Risks
Tail risks, or the risks of extreme and unlikely events, can have a significant impact on bond investments, leading to potential losses.
You could also very well argue that this list of factors is relatively superficial.
Trading is a complex endeavor that involves navigating many different variables and facing high competition in adversarial markets.
In the traditional media or on social media, you will see many opinions, but most are sound bites that don’t take into account the complexity of a situation.
Even a very simple returns stream like interest in a bank account is not intuitive to most.
For example, if someone’s getting 5% interest in a savings account, they might assume their purchasing power is growing by 5% per year, believing nominal returns is the same as real returns.
However, there are taxes and there’s an inflation rate. Everything has to be contextualized for buying power and after all expenses and fees.
So, if the interest is being taxed at 20% and there’s a 4% inflation rate, the real return is 0% – neither gaining nor losing purchasing power.
Like most things, it’s a bit more complicated than it appears on the surface.