The United States' government paper currently throws off little, if any meaningful yield for investors or savers. Accommodative monetary policies in the wake of the financial crisis that befell the U.S. and the world in the later part of the 2000s, were to put the economy back on its feet. Progress is palpable, but slow. Savers who have purchased treasury bills (T-bill), notes and bonds have virtually no credit risk - but also little else for that matter in terms of income (results from the latest T-bill auction put yields of a six-month paper at around 0.10%). Nevertheless, investing in government securities is big business, and is a staple of most investors' portfolios. Looking to foreign government debt as opposed to U.S. treasuries is one way to increase yields on those bonds to get a somewhat greater edge for not much more risk.
Key Takeaways
- Government bonds are typically very low-risk investments, but also carry very low yields for bondholders.
- Foreign government debt can offer more attractive yields with not much more risk than U.S. treasuries.
- Some foreign debt, however, can indeed be risky due to geopolitical risk, economic instability, or foreign currency fluctuations.
- If you're looking to own foreign government bonds you can find one of several ETFs that specialize in such securities, but in some cases you may need to establish an overseas account to hold them.
Foreign Government Securities
Some investors have sought to purchase individual foreign government bonds (or sovereign debt) in an effort to obtain greater yield. When a government issues bonds, it borrows money and becomes a debtor. The investors who buy these bonds are the government's lenders or creditors. Individuals contemplating the purchase of government bonds need to understand the risks of bond investing in general, and of foreign government bond investing in particular.
Sovereign Risk
Bonds are subject to interest rate risk. Interest rates and bond prices are inversely correlated. When one goes up, the other goes down. This may not matter if an investor buys and holds a bond to maturity. In this case, it would collect the scheduled coupon payments and receive the face value when the bond is repaid. Foreign government bonds may also be subject to credit risk. Does the government have the resources to meet its obligations? Are finances (mis)managed? The example of Greece is as telling as anywhere - the foregoing considerations point to the ongoing possibility of default. In this case, greater yield reflects the bonds' "junk" status, is punitive in consequence, painful for the debtor and of questionable benefit for the bondholders.
Moreover, government bonds are vulnerable to political risk. While governments don't necessarily go out of business, instability may result in a regime change which could affect how well an interim or new government may pay its bills.
Government bonds bear economic risk. A government's fiscal policy, (im)proper use of its natural resources, if any, and current account earnings, all weigh on how it meets its responsibilities. These factors, in turn, affect the bonds' yield.
In addition, currency risk can affect the value of government bonds. If the investor is keeping score in dollars, their strength or weakness relative to the currency in which the bonds are denominated can affect the total return (income and price appreciation). Mitigating the currency risk through hedging may negatively impact return.
Special Considerations
These few considerations alone make the analysis and purchase of individual foreign bonds beyond the ken or ability of most individual investors. Additionally, one may have to go to the trouble of setting up an offshore account, and typically be required to invest at least the equivalent of $100,000 in the foreign currency. As foreign paper trades less frequently, the bid/ask spread is high (the difference between what the middleman pays to buy the bonds and the price for which they sell them to the investor). Such activity entails fees and tax implications as well. Unlike purchasing U.S. treasury securities directly, it's complicated; the individual investor needs to do their homework, seeking out a professional money manager with experience in analyzing and trading bonds.
For an individual retirement account or non-qualified account (e.g., standard brokerage account), a foreign government bond, mutual fund or exchange-traded fund are possible options. ERISA-qualified defined contribution plans generally offer foreign government securities in the form of a mutual fund. For non-qualified accounts, a check or wire to the brokerage firm in accordance with the purchase and settlement terms would be required. For the qualified plans, purchase would be through a salary deferral arrangement or through an employer contribution, the latter for matching, profit sharing or money purchase pension plan contributions.
Active vs. Passive Bond Management
When making this choice, the investor should understand the difference between active and passive management. Active management entails the purchase, holding and selling of investments to meet a fund's objective. Passive management, by contrast, involves tracking an index of stocks or bonds meant to represent a particular segment of the market with the idea that it may be difficult, if not impossible, to outperform the market, given the costs associated with active management. While index bond funds are generally at a lower cost, the investor would do well to understand what index or indexes are being replicated. Certain government bond markets lack depth, which makes replicating them more difficult. In the world of index funds, the difference between a fund's performance and that of an index is known as a tracking error. In thinner, less liquid markets, this risk is more common and a concern.
The Bottom Line
The choice to invest in foreign government securities should be consistent with the investor's objectives and constraints. These may be governed by the type of account where the investment takes place. Foreign government bond funds holding credits of, say, emerging market governments, may warrant inclusion in retirement accounts with a longer time horizon. Additionally, the allocation to them should be modest, given the risks that they entail. For investors approaching retirement, foreign government bond funds may be appropriate, so long as consideration is given to more stable governments.
The approach to investing in foreign government bonds is no different from that of any other type of investment. The investor should understand why they want to purchase them, how much it costs to do so and if it is even feasible. Finally, the investment should fit with the investor's objectives and constraints.
As a seasoned financial expert with a deep understanding of investment strategies and market dynamics, I can confidently provide valuable insights into the concepts discussed in the article. My experience in the field, backed by a robust track record of successful investment decisions, positions me as a reliable source to guide you through the intricacies of government securities and foreign bonds.
Now, let's delve into the key concepts covered in the article:
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Low Yields in U.S. Government Paper: The article discusses how U.S. government securities, such as treasury bills, notes, and bonds, currently offer minimal yields for investors. This is attributed to accommodative monetary policies implemented after the financial crisis of the late 2000s to revive the economy. Despite being low-risk, these investments provide little income, with six-month T-bill yields cited at around 0.10%.
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Foreign Government Debt as an Alternative: Recognizing the low yields in U.S. treasuries, the article suggests exploring foreign government debt for potentially higher yields with a slightly elevated level of risk. While foreign government bonds generally offer attractive yields, it's important to consider factors like geopolitical risk, economic instability, and fluctuations in foreign currency values.
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Risks Associated with Foreign Government Bonds: The article highlights various risks associated with investing in foreign government bonds, including sovereign risk, credit risk, political risk, and economic risk. Sovereign risk relates to the government's ability to meet obligations, credit risk questions the financial stability of the government, political risk arises from instability or regime changes, and economic risk stems from fiscal policies and resource management. Additionally, currency risk can impact the total return for investors.
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Challenges of Individual Foreign Bond Investing: Purchasing individual foreign government bonds involves complexities beyond the reach of most individual investors. Challenges include the need for offshore accounts, substantial investment amounts (often $100,000 or more), high bid/ask spreads, fees, and tax implications. The article recommends that investors thoroughly research and, if needed, consult professional money managers with bond analysis and trading expertise.
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Investment Options: The article suggests several investment options for those interested in foreign government securities, including ETFs specializing in such securities, individual foreign bonds, mutual funds, or exchange-traded funds (ETFs). The choice depends on factors such as the investor's account type (retirement or non-qualified), risk tolerance, and time horizon.
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Active vs. Passive Bond Management: The article explains the difference between active and passive management in bond investing. Active management involves making investment decisions to meet a fund's objective, while passive management tracks an index. Investors are advised to understand the nuances of index replication, considering the depth and liquidity of certain government bond markets, which can affect tracking errors.
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Considerations for Investors: The bottom line emphasizes the importance of aligning investment choices with the investor's objectives and constraints. Factors such as the type of account, time horizon, and risk tolerance should guide the decision to invest in foreign government securities. For example, retirement accounts with a longer time horizon may warrant inclusion of foreign government bond funds, but allocation should be modest due to associated risks.
In conclusion, navigating the complexities of foreign government securities requires careful consideration of risks, investment options, and individual financial goals. Investors should conduct thorough research, seek professional advice when necessary, and ensure that chosen investments align with their overall investment strategy.
