International Bond Funds
What it is:
How it works (Example):
International bond funds come in many shapes and sizes. Some only invest in foreign bonds with certain types of coupons, certain types of issuers, certain types of trading characteristics (convertibles, for example), certain types of credit ratings, etc.
How International Bond Funds Work
Like other bond funds, international bond funds are composed of bonds, but they don't always behave like bonds. First, international bond funds do not mature like individual international bonds do. Instead, fund managers buy and sell international bonds of differing maturities, which produces constantly changing profits, losses, and yields. Although an international bond fund's investments do mature, the fund's investors typically don't get their original investments back until they sell their shares (and index funden then there is no guarantee the fund's share price won't be below the investor's purchase price).
Second, international bond funds usually make monthly payments to investors, while international bonds normally make only semiannual payments. Thus, international bond funds provide more frequent income and a better opportunity to leverage the power of compounding when reinvesting.
One major disadvantage of international bond funds (and bond funds in general) is that lower interest rates don't always mean higher prices. When investors buy shares of an international bond fund, the fund manager purchases more bonds with the proceeds. In a declining interest-rate environment, this means that the manager is probably buying bonds with lower coupons than before, when rates were high. The inclusion of these low-rate bonds in the fund lowers overall returns and the income available to investors. This in turn lowers the fund's share price, incentivizing investors to sell and putting more downward pressure on the fund's share price.
International bond funds carry more risk than most other bond funds because in addition to exposing the investor to default and interest-rate risk, they also expose the investor to exchange-rate risk and political risk. Many investors are willing to deal with these risks, however, due to the extra returns often associated with them.
Like other mutual funds, there are load and no-load funds, but in general larger funds should have lower fees due to their economies of scale. International bond funds tend to have higher fees than other bond funds because the underlying assets are less liquid and thus incur higher trading costs. Larger funds may offer lower fees and pay less for large blocks of bonds, but investors should not ignore small funds. Small funds often take meaningful positions in smaller issues that large funds cannot or will not look at. Also, small funds are often better able to exit certain positions because they have less impact on market prices.
Why it Matters:
International bond funds offer the services of a professional who watches and acts on the global interest rate environment, handles the trading decisions, and determines asset allocation on behalf of the investor. Fees for these services, however, can eat into returns. The most important document to study is the prospectus, which provides information about those fees as well as the bond fund's investment methods, goals and strategies, and a list of specific holdings.
Most investors agree that it is usually easier and less expensive to invest in international bond funds than to choose each and every international bond in a portfolio. More importantly, an international bond fund's instant diversification often means lower risk. A single default could have dramatic consequences if the investor holds one or two international bonds outright; but owning many bonds in a fund eliminates some of that risk. Funds also are a way to avoid the often higher transaction costs and lower liquidity associated with trading individual international bonds; it's often easier to sell bond fund shares than to sell a particular international bond.