The influence of currency denomination on the risks and profits of a bond

Foreign-denominated bond investments can offer attractive returns, but they also come with a unique risk: currency risk. This risk arises when investing in bonds issued in currencies other than the investor's domestic currency. Let's delve into the factors that influence currency movements and returns on foreign-denominated bond investments.

When a foreign currency depreciates, each coupon payment becomes worth less when converted to the investor's domestic currency. For example, the Japanese Yen has weakened against the US Dollar, reducing the value of the coupon payments for a Japanese bond held by a US investor. However, when a currency appreciates, such as the Euro strengthening to 1.10 US Dollars, each coupon payment becomes worth more. This appreciation positively impacts both coupon payments and principal repayment of foreign-denominated bonds.

Interest rate differentials between countries play a crucial role in currency movements and returns on foreign-denominated bond investments. When a country's interest rates rise relative to other countries, it typically attracts foreign capital seeking higher returns, leading to currency appreciation. Conversely, a decrease in interest rates may cause currency depreciation.

Central banks' monetary policies significantly influence exchange rates and, consequently, the returns on foreign-denominated bond investments. For instance, political scandals and high volatility in Turkey led to a significant depreciation of the Turkish Lira, reaching a record low of 37.665 against the US Dollar in March 2025. In contrast, some currencies like the Swiss Franc and Mexican Peso showed notable appreciation, while countries such as China saw increases in foreign exchange reserves, suggesting relative currency strength.

Carefully considering these factors can help you better understand the forces driving currency movements and make more informed investment decisions about your foreign-denominated bond portfolio. Hedging can be an effective method for mitigating currency risk. Currency hedging involves using financial instruments like forward contracts or options to lock in a specific exchange rate.

Diversification is a crucial strategy for managing currency risk in foreign-denominated bond investments. Investing in bonds denominated in various currencies can spread your exposure and reduce the impact of adverse currency movements. Currency appreciation can enhance returns on foreign-denominated bonds, but currency depreciation can diminish returns by reducing the value of principal repayment and eroding the value of income.

In conclusion, understanding currency risk is essential for making informed decisions in foreign-denominated bond investments. By considering factors such as interest rate differentials, central bank policies, and economic conditions, investors can make more strategic decisions to mitigate risk and potentially enhance returns.

The influence of currency denomination on the risks and profits of a bond