The Risks of Investing in Foreign Government Bonds

Muncipal bonds or “munis”, U.S. treasury bonds and most other forms of government bonds are, by comparison to other investments, usually considered safe and secure investments. However, not all governments are created equally and, therefore like all other forms of investments some government bonds carry greater risk. For example, foreign government bonds may be subject to greater investment risk as a consequence of the reckless or misguided fiscal policy of that sovereign nation.

Apart from Moody’s rating system what are the ways to determine if a foreign government bond carries unusual or unaccpetable risk?

Some ways to assess the risk-reward of foreign government bonds include consideration of the stability of the bond’s native currency, the long term or future prospects of government stability, and current events, both global and domestic, that can affect a nation’s economy.

The stability of the underlying currency of a bond can be a significant factor affecting bond risk. Some countries may attempt to offset the inflation/currency risk of their bonds by offering higher interest rates. One must be mindful of indications that inflation may strip away the benefits of a higher interest rate. This is not a risk solely associated with foreign bonds. All bonds have this “…risk of a loss of principal when interest rates rise”.

An investor can also look at the current events to simulate the risk of a government bond. Instability of the government can make the bond less appealing, and make it a riskier investment. Take, for example, how on May 24, 2010 Spain seized a “troubled regional bank”. This larger scale or “regional financial instability” created uncertainty and a lack of trust in the Spanish government’s ability to repay debts. Being part of the European Union (EU), Spain’s difficulties could/would affect all of its members, making uncertainty arise across all of its members.  Unlike the American government, which can print more money if there is trouble paying the owed bond, the Spanish government cannot print more money, since it is not just their currency.

A recent event that may illustrate how a bond could be riskier than one would expect would be the large scale labor strikes in Greece, along with its international rescue loans worth $140 billion.  Bailouts of this magnitude can cause trust to dissolve in the government and the taint may last for years or decades. Even if Greek government bonds were propped up by assurances from the central bankers of the E.U. it is likely that their bonds will be steeply discounted for the foreseeable future.

By – Domenic Gabriella