Americans are hungry -- starving actually -- for something they had come to expect: healthy investment yields. But the past two years have been brutal for those who rely on fixed-income investments such as U.S. Treasuries and corporate bonds, with returns hovering at or near record lows.
Against that backdrop, investing in the sovereign debt of foreign countries can look very attractive.
Take Ireland and Greece. The yields on their 10-year government bonds reached a sky-high 9 percent and 11 percent in February, respectively. But with the generous returns come more risk than investors realize.
"The risk side of it is being ignored as people hunt around to try to get a higher rate of return," says Kent Grealish, a registered investment adviser and co-owner of Quacera Capital Management in San Bruno, Calif.
Indeed, the search for higher returns in risky foreign government bonds is just part of an overall rise in investors' appetite for high-risk, high-reward bonds known informally as junk bonds, Grealish says.
Credit risk a big gamble
Hildy Richelson, president of the Scarsdale Investment Group in Blue Bell, Pa., says credit risk is one of the biggest gambles that investors take when they invest in foreign government bonds, especially with so many countries carrying record levels of debt.
All bonds carry some credit risk, or the danger that the bond issuer won't be able to pay the interest or principal when due. Grealish says that risk can be almost nonexistent with U.S. Treasury bonds or very significant with junk bonds rated less than a "BB" by credit rating agencies such as Moody's.
Like corporations, governments sometimes default on all or part of their debts, suspending payments or restructuring the bonds to relieve financial distress at the expense of private bondholders. From 1999 to 2009, there were 17 incidents of sovereign default involving such countries as Russia, Indonesia and Argentina, according to data from Standard & Poor's.
And even if a government doesn't actually default on its debts, downgrades in the country's credit quality can cause the price of any of its bonds to fall, causing investors who sell their bonds to take a loss, Grealish says.
In the past, developing countries often presented the greatest risk of default. But Richelson says some developed countries may default in the next few years. Greece is carrying more than 100 percent of its gross domestic product in debt and troubled economies such as Italy and Ireland are not far behind.
Currency fluctuations pose risk
Earning money on your investments abroad is all well and good, but eventually you've got to bring that money back home to spend. When that happens, you'll not only see your earnings eroded by significant foreign exchange conversion fees, but even small movements in the value of international currency can have a huge influence on your overall return, Richelson says.
"Instead of getting the touted 7 percent or 8 percent, you end up getting 3 percent or 4 percent," Richelson says.