The Role of Bonds in a Portfolio and Foreign Bonds

A while back I was talking with a friend of mine in the money management industry. I asked him if any of his high net worth clients bought non-US bonds in their accounts (the securities are held in the name of the client, but the advisor helps with selections) and he said one of them picked up a big position in Australian bonds. How did he do? I asked. The answer:

His bond positions increased significantly in value

Why is this? And what was the client trying to accomplish?

The client was likely looking for an increase in the value of the Australian currency against the US dollar, and buying bonds as a proxy for this bet. Bonds have the advantage of paying off interest as well as providing diversification from the US dollar, but in the case of this Australian debt, the percentage of the return that came from the increase of the Australian dollar vs. the US dollar provided most of the gain. The Australian dollar was as low as 63 cents per USD in late 2008 / early 2009 and is now at over $1.03 per USD as of mid 2012. That is a 95% gain! Any interest income or changes in creditworthiness (short of seismic market events like the Greek default) don’t move the return like this.

His client wasn’t the only one. At about that same time I talked to another professional who also said that the commodity producing countries were going to have stronger currencies relative to the US dollar, and was making his equity picks accordingly. If you bought an Australian ADR on an Australian exchange in 2008/9, in US dollar terms it would also be up an additional 95% (give or take some) in US currency when compared on a similar apples to apples basis, before taking into account the performance of the underlying stocks. Google Finance offers a simple graphing tool to see the performance of various currencies against one another over multiple time periods – the US dollar vs. Australian dollar is here.

Let’s look at BHP (Broken Hill Proprietary), the massive mining conglomerate out of Australia. On the ASX (Australian stock exchange) you can see that the price was about $25 in late 2008-9 when the Australian currency was at its nadir and the price today on the ASX is around $32, a gain of about 28%. However, the price of BHP as an ADR listed on the US stock exchange (which is exactly the same instrument, denominated in US dollars) was drastically different – it went from around $35 to $65, a gain of 86%. The difference in the change of the currency contributed to over 2/3 of the total gain during this period.

A different example is Bankocolumbia. Here is a graph of the Columbian Peso (COP) vs. the USD per Google Finance for the year to date through mid 2012. The Columbian peso is up almost 10% vs. the US dollar during this time. The ADR for Bancolombia S.A. (CIB) is up about 9% during the year (listed in the US on the NYSE). Bankocolumbia listed on the Columbian exchange (and obviously denominated in Columbian dollars) can be found on Reuters (Google apparently doesn’t include the Columbian exchange in its price history) and the price has been roughly flat during the year to date ended June 2012 at a price of around 27,000 CP.

Based on these examples if you know 1) the performance of the stock on its “home” exchange 2) the performance of the currency vs. the US dollar 3) the performance of its ADR on a US exchange, you can see the portion of the return that is “currency based” and the portion of the return that is “stock based”.

While sophisticated investors have known about the impact of currency changes on portfolios for decades, given the relatively rapid (in years, not decades) shifts in relative currencies that is occurring today, it is important that smaller investors start to understand the impact of these currency changes on their investments.

The most important part of the view is what you DON’T see on your (relatively worthless) brokerage statement – the “absolute” return of your dollar denominated assets relative to what they would be if they were denominated in other currencies. By this (theoretical) example, if you held assets in US dollars, and you could have had those same assets held in Japanese Yen over the same period, you lost 35% of your value over the last 5 years due to the decline of the US dollar vs. the Japanese yen. Until a turnaround in 2012, the US dollar had been declining against virtually every other major currency in the world, and reducing returns in the US in absolute terms, as a result, whether we noted it or not in our statements.

Thus the conclusion (this is obvious, sorry) is that the relative return of stock instruments is substantially impacted by currency returns, and thus if you are selecting an ADR of a foreign country you are betting on 1) the future price of the stock vs. today’s price 2) an increase or decrease in that country’s currency vs. the US dollar, with increases in that country’s currency vs. the dollar “boosting” your return here in that stock in the US. This can be seen clearly by the three components listed above. Since stock investors are (generally) trying to earn a long term return above inflation and inclined to take some risks, these risks are reasonable given the “mission” of stock investing and thus is in line with investor motives (depending on their risk profile).

For instance, why are people discussing the relative merit of a split of stocks vs. bonds vs. cash? When I sign into my brokerage online what jumps up instantly is a split of my instruments and a split of what is stock vs. bonds. This is due to the fact that there is a basic premise that “stocks are risky money” and “bonds are safe money”, thus investors should split their dollars between these two pools of money in order to provide for upside risk (stocks) and avoid downside risks (bonds).

A recent New York Times article titled “The Search for Calm In Bond Markets” discusses this impact among other issues in the article.

A 2011 study by the Vanguard group showed that currency fluctuations, not market moves, account for a vast majority of the overall volatility in foreign bonds.

Thus what are you trying to accomplish with bonds in the first place? Is it preservation of capital and “keeping up” with inflation, which is the implied theme in most investing literature? If this is the case, then investing in foreign bonds generally violates this “purpose” of investing in debt.

However, another “implied” conceit underlying the typical bond / stock discussion is that depreciation or decline in the value of the “base” currency (the US dollar, for this discussion) doesn’t really matter, when in fact it matters greatly, especially over time. The net value lost to US citizens caused by the US government’s zero interest rate policy (ZIRP) which contributes to the currency’s decline, along with other elements, is very significant and over 30% depending on how you measure us against other economies and currencies.

To jump around a bit more, CIB (the Columbian bank) is now issuing debt for Western (US investors), denominated in US dollars! While debt doesn’t always directly impact a stock price, moves in a currency now could significantly impact the company depending on whether or not that debt is hedged against the dollar (and if it is hedged, the cost of those hedges must be considered in addition to the interest rate on the debt from the perspective of a stock holder, since it isn’t free). Recently I wrote about the vast riskiness of these plays, given that currencies can move significantly and the issuer must be prepared for these moves. CIB issued $1 Billion in bonds denominated in US dollars with a 10 year maturity payable annually at an interest rate of about 6%. Western investors who are hungry for yield apparently snapped up the bonds, and this went virtually unnoticed in the popular press. Given the (stale) perception of Columbia as a drug haven tied to virtual civil war, it is pretty amazing that they are now able to borrow $1 Billion US dollars at 6% over a period of 10 years and it isn’t news anymore. I hope whomever bought those bonds understands the risks, and the fact that 1) this is Columbia, not a state down the street 2) the bonds are denominated in US dollars and CIB needs to be prepared for swings in relative values of currencies, which have moved over 25% on a given year 3) 6% is a rate that would have been unheard of even 5 years ago.

If I was advising someone getting into the finance industry today I’d say that bonds is where the action is, not stocks. Bonds range from some of the most risky instruments on the low or high end and encompass all sorts of risks and opportunities. To someone just looking at bonds as a safe asset class, you are missing the mark.


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