One of the best ways to mitigate risks when it comes to investments is diversification. Not only is it important to invest in various sectors but also well worth looking at foreign or international bonds as a viable investment option. Foreign bonds accord the investor protection from fluctuations in the domestic markets and accord higher interest rates (when invested wisely). Income from foreign or international bonds is, however, subject to foreign exchange or currency fluctuations. It is important to understand the impact of fluctuating forex rates on foreign bonds before you invest.
Understanding Foreign Bonds
A foreign bond is a bond that is issued by either a foreign financial institution or company and is pegged to the domestic currency (of the country where it is issued). It could also be a bond denominated to a currency other than a domestic currency. For example, a situation when a UK based financial institution issues a bond in India and the bond is pegged to the US Dollar. A foreign pay bond is issued by the local financial institution but is benchmarked to a foreign currency such as a US dollar-denominated bond issued by the RBI.
Forex Fluctuation and Returns
To understand how forex fluctuations influence returns on foreign bonds let us consider this scenario. Say you buy INR 10 lakh worth bonds denominated in US Dollars. The day these bonds are bought let us assume that the USD-INR conversion rate is 70. This means that one USD will cost about INR 70. Now having held the bonds for a year you decide to sell them and let us assume that the value of the bonds has not changed over this period. Now on the day you sell these bonds, the value of the US Dollar has fallen about 5% against the Indian Rupee. Now even though the value of the bonds (in USD) remains the same, as a foreign investor your wealth has depreciated by 5 % during this period and you end up losing some of the investment.
This means that when the Indian rupee is strong your return on investment (ROI) on foreign bonds is negatively impacted and when the domestic currency is weaker, you can expect a higher ROI (when the bond performance in both scenarios is the same).
The Hedging Option
Many investment managers and fund managers working in the international market try to mitigate the risk of forex fluctuations by hedging. Sometimes this involves buying foreign bonds with a rider so that the returns will be offered at the value of the domestic currency on the date of purchase. This, however, involves additional costs and also could reduce the ROI if the currency fluctuation is favourable during the period of holding. This is a process similar to that employed when you take a loan against gold in India. The interest could be a fixed one or a variable one depending on the gold rate.
Overall the foreign bond is a good investment option, particularly when the bond value of currencies of developed countries is at a high. The returns on these bonds, however, must be estimated keeping in mind the possible fluctuations in exchange rates. A thorough understanding of the domestic economy and the domestic currency’s movement weighed against the foreign currency is necessary before making such investment.