A Risky Way to Reach for Yield

For years, cash-needy investors have been pulling out all the stops to try to boost their portfolio income. From mortgage REITs to master limited partnerships, previously little-known asset classes have drawn a lot of attention from investors who might never have even known about them before -- let alone considered them seriously.

In order to meet the demand for income, Wall Street's fund companies have been hard at work developing products designed to give investors the cash they need. One area that's gotten a lot of attention lately has been the international bond arena. Although there are unquestionably some promising opportunities in the international bond market, it also comes with more risk than many bond investors are used to seeing.

Do you really need foreign bonds?
When you look at recent returns on U.S. bonds, you'll see some pretty impressive figures. Over the past two years, for example, the iShares iBoxx Investment Grade Corporate ETF (NYSE: LQD  ) has paid returns of 9% annually. The SPDR Barclays High Yield Bond ETF (NYSE: JNK  ) , which focuses on lower-quality junk bonds, has done even better, posting a 10.7% annual return.

But returns on Treasuries have crushed even those impressive figures. The iShares Barclays 20+ Year Treasury ETF has climbed an average of almost 16% each year since 2010.

Why foreign bonds are interesting
With those great performance figures, why do you need foreign bonds at all? The problem U.S. bonds face is that with yields near historic lows, there's not as much capacity to produce the big capital gains that have driven bond funds higher.

By contrast, rates in some other parts of the world are much higher. In Australia, for instance, three-month bonds yield more than 3%, compared to returns of less than 0.1% on U.S. Treasury bills. Brazil offers even better rates, with long-term bonds in the five- to nine-year maturity range yielding close to 10%.

Bond returns are a function of two things: the amount of interest the bond pays and any changes in price while you own the bond. If you own an individual bond and plan to hold it until it matures, then those price changes become largely immaterial; you'll see its value fluctuate on paper, but at maturity, you'll get the agreed-upon face amount of the bond back. But if you own a fund, rate changes do matter.

As a result, higher yields on bonds give investors two advantages. First, you get more current income from your investment. But second, a high rate has more room to come down -- and if it does come down, the value of your bond holdings can rise substantially.

That potential double-reward has driven a lot of interest in foreign bond funds. For example, the closed-end Aberdeen Asia-Pacific Income (NYSE: FAX  ) has a portfolio of most Australian and Southeast Asian bonds and pays a dividend yield of almost 6%. Templeton Global Income (NYSE: GIM  ) , which has a broader scope, also yields in the 6% range. Compared to rock-bottom rates on U.S., Japanese, and German debt securities, those yields look awfully attractive to many investors.

Know the risks
But these potential rewards don't come without a cost. In particular, foreign bond funds can introduce a new risk for U.S. investors: foreign currency risk. Some funds, including iShares JPMorgan USD Emerging Markets ETF, use only bonds that are denominated in U.S. dollars, taking away any potential currency risk. But others, such as WisdomTree Emerging Markets Local Debt (NYSE: ELD  ) , use debt that's denominated in the local currency, leaving you completely exposed to exchange-rate fluctuations.

With the dollar having been under pressure during many of the past several years, exchange-rate risk has actually boosted returns of foreign bonds in U.S. dollar terms. But there's no guarantee of that continuing -- and with the dollar having asserted its strength against both the euro and some emerging currencies like the Brazilian real lately, recent investors have learned about the potential downside of foreign bonds.

No free lunch
If you're simply interested in diversifying your bond portfolio beyond the U.S., then foreign bonds make a lot of sense. But before you use them as a speculative tool to jump onto the latest hot fad in funds, be sure you're aware of the risks involved. If you rely on past results to guide your expectations, you could easily end up sorely disappointed.

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Fool contributor Dan Caplinger prefers taking calculated risks. You can follow him on Twitter @DanCaplinger. He doesn't own shares of the funds mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy works the whole world round.


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