Imagine you have $1,000 and you want to invest it to get the best return with the lowest amount of risk (which, very often, is the ultimate goal in finance) over the next 12 months, with a very small risk of losing principal. You have three options:
- Invest in a SPAC currently priced at a 20% premium to book value.
- Invest in a large-cap stock current priced at a 10% discount to book value.
- Buy a foreign bond issued in a foreign currency yielding 8% in local currency terms.
- Put the money in a savings account yielding 1.5% annually.
Which do you choose? Now, there are some obvious silly options we can dismiss—SPACs are risky and volatile almost by definition, and large-cap stocks, regardless of valuation, are also risky over the short term as equity market volatility is unpredictable, again almost by definition.
Now, do you get the FDIC-guaranteed 1.5% yield from #4 or go for the 8% yield from a foreign bond? Again, this might seem like an easy question—you go for the last option as it is the best return—and this would indeed be the best option for most retail investors and average middle class people. But it isn’t necessarily the best option in other situations, and answering this question is surprisingly difficult.
The answer isn’t easy because there are a lot of variables to address, and those variables matter the most when trying to answer this question.
The first would most likely be default risk. A foreign bond in a foreign currency can mean a lot of things—is the issuance from a government? What are the default risks of that government? Buying an 8% yielding bond from, say, the United Kingdom will have a very different risk profile than buying that same bond from Argentina, Uganda, or China.
There’s much more to parse, however. We would also need to look at inflation rates. Remember that a bond’s coupon is just the neutral yield of the investment, but it is not the real interest rate of the investment, which is that yield minus inflation. If the foreign currency is showing lower inflation than your native currency, that 8% could suddenly become extremely attractive.
However, there is also currency risk. With #3, you could find yourself losing income in local currency terms if there’s a chance of that currency weakening substantially. Americans in particular are keen to perceive this risk in foreign investments—but many foreign investors see it quite the opposite, with risks of their currency weakening as greater than risks of the USD weakening—hence the popularity of USD-denominated investments (including the dollar itself) around the world.
Of course, there is interest rate risk, and I’ve saved this for last because it’s the most talked about and easily most overhyped risk to bond values out there. When central banks start raising interest rates, the value of issued bonds tend to fall, because newly issued bonds yield more than the old ones, making the resale value of the old bonds fall. If you don’t sell your bond this won’t matter to you, but the longer the duration of the bond the longer your money is locked up—a reason why longer denominated bonds fall in value when rates rise (and, in some cases, short-term bonds will rise in value due to demand). When dealing with a foreign bond, however, you’re now dealing with two central banks—your own and a foreign one—so you will need to assess this risk with both banks in mind.
There are more issues to consider, but let’s stop for a moment and consider one possible answer to this question that might prove controversial: #4, from a risk/reward standpoint, could be argued to be the worst of all options because it is guaranteed to lose money (or at least, guaranteed to lose money in most market conditions). A 1.5% interest rate is less than inflation targets in most countries (the Federal Reserve’s target is 2%), meaning in real terms the yield is actually negative on this investment. And there’s no upside—so you are pretty much guaranteed to lose your money.
Of course, all other scenarios bring up new risks—risks of overvaluation in #1, risks of market volatility in #2, and the bond-related risks discussed above in #3. That’s just to start—we’ve barely scratched the surface of the multi-dimensional risks involved in all of these options. But only #4 offers risks without reward—even if, admittedly, its risks are microscopic.
This is a big reason why diversification is so important in finance and often called the only free lunch out there. Diversification means you are exposed to many risks at once—but you also identify those risks, control for them, and limit exposure according to what’s best for your goals and for market conditions. But being diversified and planning to identify and assess risks are very difficult—and they’re where the creativity, analytical prowess, and ability to understand markets of an analyst provide tremendous value.