If you want a truly spine-tingling investment ride, you likely could do no better than foreign government bonds, also known as “sovereigns.”
The risks are multiple: Beside the typical risks of bonds, such as interest rate risk and inflation risk, you have to add on top currency risk, political risk and repayment risk.
The reason that emerging-market sovereign pays a fat yield is all that risk. Let’s break it down a bit:
Interest rate risk
This is the easiest to understand. If interest rates rise, the market-price (resale) value of your bond can fall dramatically. For example, if you own a 10-year bond paying 4% and rates rise to 6%, very few people will be interested in taking on your old bonds without a cut in price to offset the difference in income.
If you buy a bond at a set interest rate, say 5%, your real value will be determined by how much inflation eats away at the yield. So, if inflation is 2%, your real payout will be the difference of 3%.
Sounds simple, but foreign inflation rates can be quite high. A bond paying 12% is suddenly less attractive if local inflation is running at 10%.
Say you own a bond priced in an obscure European currency. It does okay, yielding 7%, but when you go to move your money back into dollars (or euros or yen) you find the exchange rate is working against you, wiping the yield to maybe 2%. Now you’ve just kept up with inflation, not quite the investment you wanted.
Investors flock to higher yields but few take a moment to question the rush. Is the government issuing the bond stable? Is there rule of law? How do the court systems work?
Experienced bond traders have rows of analysts working around the clock to produce up-to-the-minute insights into these issues. Such information might be priced in, but not always. A sudden turn of events or change of government can torpedo your investment without warning.
The ultimate bond nightmare: The country is broke and repudiates its debts. It’s hard on the nation in question, for sure. They’ll be dealing with years or decades of austerity and little access to fresh credit. For bond investors, however, it might mean a haircut of 50% or 90% or all of it, gone with the wind.
How can a retirement investor get into this market? Very, very carefully. One good way is to avoid the direct investment route and instead own a broad exchange-traded fund (ETF) that holds many sovereign bonds.
Using an ETF, you get the exposure to the asset class in a precise measure without taking on the immense risk of a single country’s fortunes. And you can do so inexpensively, through a liquid, traded security in your own home market.
Sovereign bonds are an important part of a balanced retirement portfolio, so long as you take measured risks in doing so.