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The Short Answer

What a Rate Hike Here Could Mean for Foreign Bonds

We delve into how foreign-bond funds performed in previous rising-rate environments and find some surprising results.

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Question: I've heard the Federal Reserve might raise interest rates soon. I know that's supposed to be bad for my U.S. bond funds, but would it hurt my international-bond funds as well?

Answer: After years of hand-wringing over when the Fed will end its accommodative interest-rate policy, investors seem to be coming to grips with the fact that the end may finally be near. Expectations that the Fed could raise rates as early as this June have added to recent U.S. stock market volatility. But bond investors have been focused on when a rate hike might occur almost from the time rates dropped to near 0% during the 2008-09 financial crisis.

For stock investors, the fear is that a rise in rates will make it more expensive for businesses to borrow the money they need to grow, thus cutting into profits. Higher-yielding equity types that some investors view as alternatives to bonds, such as utilities and REITs, can also suffer during periods of rising interest rates--in fact, many of these sectors have struggled of late for this very reason. For bond investors, the worry is that a rise in rates will make the yields on bonds they already own less attractive, driving down their value.

But what impact might a rate hike here have on bonds from overseas?

It's difficult to say for certain, although it's reasonable to assume that higher interest rates on newly issued U.S. bonds will make them more attractive relative to foreign bonds, especially at a time when rates abroad are generally low and some foreign central banks--most notably the European Central Bank and Bank of Japan--are engaged in bond-buying stimulus programs designed to keep them there. Add in the fact that investors worldwide tend to favor U.S. bonds--and Treasuries, in particular, due to their high quality--and you have all the ingredients for a Fed rate hike potentially hurting the value of foreign bonds and funds that invest in them.

Recent History Inconclusive
A rate hike would be the first for the Fed since mid-2006. For some indication as to how foreign bonds might respond to rising rates in the U.S., let's look at how they performed back then as well as during a more recent rate "scare."

The last extended period of Fed rate-tightening lasted from June 2004 to June 2006, and bond funds that invested a substantial portion of assets in foreign issues fared relatively well over that time period. While the Barclays U.S. Aggregate Bond Index, a proxy for the U.S. investment-grade bond market, gained a cumulative 2.9% over the two years in which the Fed was raising rates, world-bond funds gained 4.3%, on average, and emerging-markets bond funds fared even better, gaining 13.5%. (Morningstar defines world-bond funds as those that invest at least 40% of assets in foreign bonds, though some invest far more than that. Emerging-markets bond funds invest more than 65% of assets in bonds from developing nations.)

That performance comes as cold comfort, however, in light of a more recent runup in rates that produced far different results.

In the summer of 2013, U.S. bond yields temporarily shot up on fears that the Fed would soon curtail its bond-buying stimulus program in what came to be known as the "taper tantrum." From May to September of that year, the yield on the 10-year Treasury shot up from 1.66% to 2.98%, sending the bond market into a tizzy. Over that four-month stretch, emerging-markets bond funds lost 11.9%, on average, while world-bond funds dropped 5.8%. The Aggregate Index, meanwhile, lost 4.2%. (For a look back at the taper tantrum's effect on various asset classes, see this article.)

The Currency Threat
Of course, the performance of bonds from overseas is determined by many factors, especially local interest rates and, to a lesser degree, U.S. rates. Another important factor, from the perspective of U.S. investors, is currency exposure. Even if a foreign bond's value remains the same, if it is denominated in the issuer's local currency and that currency loses value relative to the dollar, U.S. bondholders will lose money. That's why many foreign-bond funds hedge away currency risk--to avoid losing part of their return to currency fluctuations.

Currency risk has become an even greater concern lately as the dollar has strengthened. It recently hit a 12-year high against the euro and more recent highs against the yen and emerging-markets currencies. Many experts, including Morningstar director of economic analysis Bob Johnson, believe the strong dollar isn't going away anytime soon. That means that investors who own unhedged foreign-bond funds, which have taken a beating recently, have good cause for concern beyond interest rates.

Contributing to the strong dollar is the fact that interest rates in much of the world remain low at a time when the U.S. may soon raise rates. As rates rise here, demand for the dollar should rise as well.

Emerging Markets Particularly Vulnerable
In recent years, income-seeking U.S. investors have been drawn to emerging-markets bonds as an attractive source of yield as compared with U.S. bonds.  Market Vectors Emerging Markets Local Currency Bond ETF (EMLC), which tracks an index of emerging-markets bonds denominated in local currencies, currently offers a 30-day SEC yield of 4.3%, far better than the 2.1% paid out by the  Vanguard Total Bond Market ETF (BND), which tracks a version of the Aggregate Index.

But as U.S. interest rates rise, and if emerging-markets bonds become riskier, it could erode that yield advantage and cause more U.S. investors to seek bond exposure closer to home. In fact, emerging-markets bond funds saw outflows of $2.3 billion in the 12-month period ended Jan. 31, while at the same time, world-bond funds saw net inflows of $13.4 billion.

None of this is to say that you should run out and sell all your foreign-bond holdings today. In fact, some bond-fund managers think foreign bonds--and emerging-markets bonds, in particular--are already so beaten down they might present long-term opportunities (GMO's Ben Inker discusses the firm's outlook for emerging-markets bonds and other asset classes in this video). The past performance of foreign bonds during recent rising-rate environments here in the U.S. only adds uncertainty.

But if you do own a foreign-bond fund, the least you can do for now is check to see where the bonds it owns are from and if it hedges currency exposure. That way, you can better understand the risks involved in owning the fund, including those unrelated to U.S. interest rates. 

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Adam Zoll does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.