Risks of Investing in Foreign Fixed Interest Securities
Foreign bonds provide investors with additional investment options and diversify a portfolio, while also carrying some unique risks.
Default risk refers to the possibility that a bond issuer fails to make interest or principal payments on time. Reinvestment risk involves reinvested returns from bonds or fixed income investments at lower-than-market interest rates.
Credit Risk
Bond investing involves lending money to an issuer – typically a government, municipality, or corporation – who promises to repay your investment with interest payments on schedule. Each bond carries some degree of credit risk – this means there’s a chance the borrower won’t meet their loan obligations; independent rating agencies assess these risks to help investors evaluate potential risks; higher-risk borrowers typically must pay higher interest rates to compensate investors for risk.
Changes in interest rate fluctuations can also cause the price of debt securities to fluctuate; investors often see greater returns with longer-maturity bonds due to less interest rate volatility; however, they carry greater risks as less liquid investments than shorter maturities.
Inflation Risk
Inflation risk refers to the possibility that investments won’t keep pace with inflation, diminishing your purchasing power. It is an inherent risk associated with investing in certain asset classes which tend to be more susceptible to inflation – for instance traditional savings accounts and fixed income investments.
Bonds in particular are susceptible to this risk as their coupon rate tends to remain fixed without adjustment for inflation. If your bond offers a nominal interest rate of 4% but inflation rises to 12% over its term, your purchasing power could quickly diminish each year.
There are ways to mitigate inflation risk, including diversifying your portfolio, avoiding long-term bonds and selecting Treasury inflation-protected securities (TIPS), which adjust their principal and coupon payments according to inflation. Real estate and commodities can also serve as good hedges against this threat, although its rise does not always occur evenly across industries or asset classes.
Currency Risk
Foreign bond investments offer investors the potential for higher yields while diversifying their portfolios, but also carry with them increased currency fluctuations and local market risks that must be factored in.
Currency risk refers to the risk of losing money due to unfavorable exchange rates between a bond’s original currency (such as euros vs dollars) and your own home currency (e.g. dollar against euro). When investing in foreign bonds denominated in euros and their exchange value increases against dollars, meaning less returns than originally invested when selling investments denominated in euros; vice versa when selling investments denominated in dollars instead.
Consider how currency fluctuations might impact your investments and find ways to hedge against potential currency risks if possible. Speak with an advisor regarding investing in foreign fixed interest securities that offer potential mitigation of currency risks.
Political Risk
Politics can cause companies conducting business abroad to experience unanticipated losses, from financial (expropriation, restriction on cash flow and nationalization of currency inconvertibility) to operational or reputational damage due to government actions and unstable socioeconomic conditions.
Foreign bonds may provide higher yields and diversify an organization’s holdings, yet these benefits must be carefully balanced against increased risks associated with issuing countries, their ability to honor debt obligations, or other related concerns.
Local market risks should also be carefully considered, including differences in accounting standards, liquidity and regulations between different countries. Issued bonds in foreign countries could expose organizations to political events such as terrorism and socioeconomic issues that impact insidiously on business operations; impacts that include slow erosion of company reputation or subtle expropriation over time. Starr’s Political Risk Insurance can assist organizations in mitigating such risks.
