The Three Key Risks of Foreign Debt

The Three Keys Risks of Foreign Debt
Posted By Steve Gunn On November 30, 2012 (4:09 pm) In 2012 Archive, Bonds, Dividend ETFs, featured, International Dividends,Market Analysis

As recently reported by The Financial Times, Franklin Templeton increased its holdings of Irish bonds by “more than a third to at least 8.4 billion [euros] in the third quarter.”

It’s a considerable move, as Franklin Templeton now controls more than 10% of Ireland’s government bond market, “snapped up by funds controlled by Michael Hasenstab, co-director of Franklin Templeton’s international bond department, and particularly by the $64 billion Templeton Global Bond Fund (TPINX) he manages.”

So far this year, the purchase has proven profitable. Irish bonds have rallied, causing yields on the 20-year government bond to drop from 8.4% to around 4.6%. This has provided significant capital gains for existing holders of Irish debt.

While the profitable trades in Irish bonds have helped Mr. Hasenstab’s fund gain more than 12% year-to-date, one might questionany move taking a dominant position in the region, given its history of volatility.

But according to Hasenstab, Ireland’s on the right track toward fixing many of its challenges and may even be a “model for other countries” to follow.

If Hasenstab’s optimism piques your interest in owning Irish debt – or if you’re considering foreign debt in general – here are three key considerations to take into account before jumping on board…

Foreign Debt Key Risk #1 – Default

ConsiderGreece. If you owned Greek debt before the country went into crisis, and didn’t liquidate your position in time, you would’ve been badly hurt, to say the least.

When a big money manager like Franklin Templeton takes a risk – and the investment in Irish debt is a big one in my opinion – they have certain advantages that we don’t. Not the least of which is knowledge.

If a country’s debt needs to be sold in short order, the fund managers will likely know well before individual investors ever catch wind of it.

And remember, all that financial aid coming fromGermanyand elsewhere is an attempt to avoid a Greek default. Hardly a bullish sign. And if a bond issuer defaults, you might lose your interest payment or some of your entire principal.

Foreign Debt Key Risk #2 – Interest Rates

If interest rates rise, bond prices fall.

It’s a basic correlation and because of it, I’ve always advised clients to buy individual bonds having a commitment to holding the bonds until they mature.

That way, even if interest rates rise, the investor is mentally prepared – and financially satisfied – to receive the income periodically, while waiting for the return of principal.

I’ve seen too many investors buy bonds thinking they could sell them whenever they wanted, only to learn the hard way about the inverse relationship between bond prices and interest rates.

Foreign Debt Key #3 – Currency

Along with foreign debt investment comes the conversion from the currency of the issuing country to the currency of the investor’s country.

This conversion can have a great impact on the net result of the investment. Whether or not your native currency is strong or weak relative to the currency in which the investment is made, can radically alter the outcome.

Not understanding how currencies interact can provide surprising and sometimes disastrous results.

Luckily, there’s a great way to go about investing in foreign debt while substantially minimizing most of all three of these complicating factors…

Mitigate and Simplify These Risks Through ETFs

For most individual investors, individual bonds – especially those in the riskier categories – should be owned through mutual funds or ETFs. Spreading out the risks in this way minimizes the impact, if a bond issuer ends up defaulting on its debt obligation

If you’re specifically looking to gain exposure to Irish bonds, I would suggest a mutual fund or ETF. And given Franklin Templeton’s aggressive acquisition of Irish debt, Hasenstab’s is probably the best place to start.

Although Morningstar gave it a solid rating of four out of five stars, note that it does carry a 4.25% front-end sales charge – a fee I like to avoid, when possible.

On a broader scale, options are slim, unfortunately.

As of today, I have uncovered no ETFs that have a meaningful amount of exposure to Irish bonds – but will let you know if and when I do.

Bonds aside, Franklin Templeton’s confidence in Irish debt is also compelling me to take a closer look at Irish stocks.

On the equity side there is one Ireland dedicated ETF, the MSCI Ireland Capped Investable Market Index Fund (EIRL).

It’s been around for about two and a half years, but it’s been averaging only 8,000 shares traded per day for the past 90-day period. And although I prefer more liquidity, in the ETF space this fund, yielding of 2.16%, is basically it as far as being exclusive to Ireland.

Bottom line: I take Templeton’s move to become dominant in the Irish government bond market, at the very least, as an indication that we should all be paying more attention to Ireland.

But the verdict’s still not in. I’m undecided as it stands and not advocating wide exposure to Ireland just yet. Stay tuned as I uncover more info.

Safe investing,

Steve Gunn

Article taken from Dividends and Income Daily - http://www.dividendsandincomedaily.com
URL to article: http://www.dividendsandincomedaily.com/2012/11/30/the-three-keys-risks-of-foreign-debt/