global investing

Insights Global Bond Investing Volume 1, Number 219 From the T. Rowe Price Information Library W hether you recently became interested in international investing or are a seasoned global investor, a quick refresher course on foreign bond investing should help you assess your current strategy and future plans for the fixed-income portion of your investment portfolio. interest, and any sale or redemption proceeds must be converted from that foreign currency back into U.S. dollars. Because foreign exchange rates fluctuate constantly with changes in each currency’s supply and demand situation, currency movements can increase or decrease the bond’s dollar value (and investment return) even if its price remains unchanged. Q. Given the added complexities, why invest abroad? A. A principal advantage of investing overseas is diversification. A diversified portfolio gives you the opportunity to enhance your overall return while reducing risk. Interest rate movements in foreign bond markets frequently do not correlate with those in the U.S. While interest rates in one or more markets may at any time be moving in the same direction as U.S. rates, longer-term correlations are low. Additionally, since interest rate levels can vary widely from country to country, a diversified portfolio may also generate higher current income than one invested in bonds of a single country. Diversification cannot assure a profit or protect against loss in a declining market. Another reason to invest overseas is the potential for higher total return. In any given year, some individual foreign bond markets are likely to outperform the U.S. bond market. Likewise, foreign bonds as a group may generate higher returns than U.S. bonds in some years but not in others. On the other hand, if foreign bond markets underperform the U.S. bond market, diversifying overseas could reduce an investor’s total return. In any case, a diversified portfolio should be cushioned from the full impact of potential losses when one market or the other has a down year. Q. What are the primary factors affecting returns on foreign bonds for U.S.-based investors? A. Many factors are the same as for U.S. bonds: interest rate levels, credit market conditions, actual and expected inflation, and the pace of economic growth, to name just a few. Naturally, a bond’s price also reflects its particular characteristics, such as credit quality and maturity and the supply and demand. There are important differences between domestic and foreign bond investing that can increase overall risk. Many countries have less political stability and less diverse economies than the United States. Political or economic upheaval in such countries could jeopardize local bond markets, so the investor must continually monitor and interpret the internal developments of other countries. However, this risk can be greatly reduced by investing in government bonds of developed nations. The aspect of foreign investing that probably generates the greatest day-to-day concern is the impact of currency translation. Initially, dollars must be converted to the local currency to purchase a foreign bond. Subsequently, price quotations, R Insights The following chart shows the world’s topperforming bond market over each of the past 10 years and illustrates how the U.S. market fared versus its international counterparts over the same time frame. Note that market leadership can change from one year to the next—the U.S. market led the field in two of the last 10 years—underscoring the importance of a well-diversified fixed-income portfolio. Best-Performing Bond Market in U.S. Dollars Year 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 Best Market Canada Sweden Canada Sweden Australia Sweden United States United States Japan France U.S. Rank Out of 13 Major Markets 11 12 2 13 13 12 1 1 4 11 Impact of Currency Fluctuations on Bond Returns to U.S. Investors for the Six Months Ended December 31, 2007 Local Market Return Australia Belgium Canada Denmark France Germany Italy Japan Netherlands Spain Sweden United Kingdom United States 3.51% -17.09 1.69 1.07 -7.30 0.66 -6.63 -15.73 -4.30 5.36 -15.80 -1.44 -1.12 Local Currency vs. U.S. Dollar 3.49% 8.26 7.78 8.04 8.26 8.26 8.26 10.54 8.26 8.26 6.10 -0.79 0.00 Return to U.S. Investors 7.13% -10.24 9.60 9.20 0.35 8.97 1.08 -6.84 3.61 14.06 -10.67 -2.21 -1.12 Source: J.P. Morgan 1988 is the earliest available year for an index of these data. Q. How can currency translation alter local market returns to U.S. investors? A. You can look at returns expressed in local currencies and compare them with the same returns expressed in U.S. dollars. If the local currency was weak versus the dollar for the period in question, the return in dollars will be lower than in local currency terms. This is because more of the local currency was needed to buy one dollar than before. But if the local currency rose against the dollar (meaning the dollar was weak), returns will be higher in U.S. dollar terms because fewer units of the local currency were needed to purchase one dollar. The following table shows returns on foreign bonds for the six months ended December 31, 2007. During this period, the U.S. dollar weakened against most currencies. As you can see, returns to U.S. investors were increased by currency translation, sometimes significantly. Source: MSCI Rimes This chart is for illustrative purposes only and does not represent an investment in any T. Rowe Price fund. Past performance cannot guarantee future results. Q. Is there any way to reduce the risk of unfavorable currency fluctuations? A. Yes. Portfolio managers may use sophisticated hedging techniques involving forward exchange contracts or options to cushion the impact of potentially negative currency movements. One type of hedge is called the direct hedge. For example, a U.S. investor buying a one-year Japanese bond may enter into a contract to exchange yen for dollars a year later at a price agreed upon when the contract is bought. This essentially eliminates changes in currency values as an unknown in the investment process. While it may protect against a currency-related loss, it also eliminates the possibility of a gain from currency fluctuations. Another type of hedge is called the proxy hedge. Continuing the previous example, a U.S. investor using a proxy hedge would look for a currency that could be expected to move with the yen and, therefore, could serve as a proxy for the Japanese currency. While a proxy hedge can be more economical than a direct hedge, it is Insights not risk free because the proxy currency may not behave as expected. Mutual fund prospectuses spell out the types of hedges a fund can use, the expected frequency of use, and the potential effects of hedging activity on a fund’s total return. Since hedging costs are treated as capital transactions, they are not reflected in a fund’s yield but rather in its net asset value. Q. Should foreign investment decisions be based on the outlook for the exchange value of the dollar? A. As the previous chart illustrates, currency translation can have considerable impact on performance, on the upside or the downside, especially in a fund with substantial unhedged assets. Over long time periods, these effects tend to diminish. Investing in foreign bonds should be viewed primarily as a way to diversify fixedincome investments as part of an overall strategy rather than as a “play” on the currency markets. Nevertheless, the impact of currency fluctuations must be taken into account when selecting foreign bond investments. Currency fluctuations should have less impact on a global fund holding U.S. dollar-denominated bonds than on a foreign bond fund without such bonds. Q. How does an investor choose among the different types of overseas bond funds? A. There are three major decisions to make: 1) between global and international funds, 2) between short- and long-term funds, and 3) between funds investing in high-quality or lower-quality (high-yield) bonds. “Global” funds invest worldwide, including in the U.S., and thus should incur significantly less overall currency risk. “International” funds usually exclude U.S. investments except in the cash reserve position (typically under 10% of net assets). “World” funds may or may not invest in the U.S.; consult the prospectus. ■ The short-term versus long-term decision should reflect your own objectives. As with all fixed-income investments, foreign bonds with shorter maturities have less interest rate risk, meaning their prices fluctuate less than longerterm bonds in response to a given change in overall interest rate levels. ■ ■ The decision between a fund investing primarily in high-quality bonds and one emphasizing lower-quality, high-yielding bonds depends on your desire for higher returns versus your tolerance for additional risk. As discussed on the next page, bond funds investing in emerging markets offer the potential for significantly higher returns but are more apt to sustain losses because of greater volatility. So if minimizing risk is an important objective, you should consider global bond funds with average maturities under five years. If you are willing to accept more day-to-day volatility in exchange for potentially higher returns over time, you may wish to investigate longer-term global or international bond funds, whose average maturities are usually five years or longer. And if you want to take an aggressive risk/reward stance with a portion of your global bond investments, you could diversify into an emerging market bond fund. While you should always keep in mind the special risks of international investing, you should also consider its significant advantages. Diversifying internationally or globally can help smooth the fluctuations of your fixed-income portfolio and can offer a way to take advantage of yields that may be higher than in the U.S. Request a prospectus or a briefer profile; each includes investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing. Insights Investing in Emerging Market Bonds Emerging market bonds are debt securities issued by governments and corporations of countries described as “less developed” or “developing” by organizations such as the World Bank. Developing countries have relatively low gross national product (GNP) per capita, and the credit quality of their bonds may be lower than an equivalent U.S. bond. These bonds carry high yields to compensate investors for their additional risk. Investing in such bonds involves substantially greater risk than investing in higher-quality foreign bonds. Prices of emerging market bonds can be severely affected not only by rising interest rates and adverse currency fluctuations, but also by the deterioration of credit quality or outright default by the issuer. Also, the low level of liquidity in emerging markets means that potential buyers may stay on the sidelines during unfavorable market conditions until bond prices are slashed. Mutual funds offer a convenient way for individuals to access the opportunities in many developing markets. Funds are, in fact, the single largest source of demand for emerging market bonds, so their cash inflows and outflows can increase the market’s volatility. However, not all emerging market bond funds are alike: some emphasize yield, some appreciation, some both equally. Portfolio asset allocations can also vary significantly, resulting in different risk profiles. If you can ride out price declines to pursue the potential of this bond market frontier, be sure to select a fund whose objectives and program are appropriate for your risk tolerance and investment time horizon. Insights articles provide background information on many aspects of investing. T. Rowe Price Investment Services, Inc., Distributor. Insights is printed on recycled paper 100 East Pratt St. Baltimore, MD 21202 1-800-638-5660 troweprice.com/insights Z10-219 3/08 72387