International bonds work in a similar manner to domestic bonds issued by the United States government or American companies. Bonds are basically a loan to a government or company. In return for making this loan, the investor who buys the bond receives interest payments and when the bond matures, the investor receives a full return of the investment. Investors considering international bonds should understand the advantages and disadvantages that these investments offer.
Individual investors have few choices for buying foreign bonds, as many foreign countries and companies do not offer bonds directly to individuals. This means that most investors will have to invest in international bonds through bond mutual funds that can buy larger bonds and pay lower fees than the individual investor. While these funds offer professional management of the bonds held by the fund, this creates both advantages and disadvantages. Though a professional fund manager may do a better job of picking bonds, the individual investors will not be able to determine which bonds to purchase. Professional management will also increase the administrative costs that the investor will pay.
Foreign Market Exposure
An investor who has interest in gaining exposure to foreign markets can use bonds as one way to invest in the economies of foreign countries or companies. Investing in foreign markets can allow an investor to profit from the growth in these countries. Foreign market investing may also be attractive for an investor during periods of decline in the American markets. Though bonds may not offer the returns of foreign stocks, they generally are safer investments.
International bonds provide investors with an added layer of diversification. Adding diversity to an investment portfolio helps to reduce the risk of substantial losses while also limiting an investor's potential return. For example, an investor who has his entire portfolio invested in one bond may profit if the bond quickly increases in value. But the investor would lose money if the bond declines in value. Adding more investments also makes the process of tracking investment performance and tax calculations more complicated.
Though the risk involved with investing in some international bonds may be higher than the risk from American bonds, these bonds often offer higher rates of return. Foreign bonds may have additional risk due to government or market instability and other factors. Whether this risk and the higher rates of return are an advantage or disadvantage for an investor depends on her specific investing needs. Choosing higher-risk investments with a higher potential rate of return may be acceptable to a younger investor but not acceptable to an investor nearing or in retirement.