The allure of overseas investments

NEW YORK (Money) -- Question: My wife and I have about $20,000 we'd like to take a chance with. I looked at Icelandic bonds and even allowing for a 1 percent transaction cost on the money exchange, they still have an attractive double-digit rate.

I know this is a weird idea, but are these bonds for real - and are they worth a try? - Bradley Hoth, Livonia, Michigan

Answer: Weird? Well, yes and no. Iceland certainly isn't the first place most people in the U.S. think of when they're looking for investments - or, for that matter, anything, I suppose other than the latest tunes from singer-composer and possibly strangest dresser in the world, Björk.

On the other hand, with the dollar taking a beating and U.S. investors plowing money into everything from international mutual funds to ETFs that let you make bets on the future direction of currencies, your question doesn't surprise me at all. In fact, the answer I'll give applies as much to foreign investments in general as it does to Icelandic bonds in particular.

Let me begin by saying that, yes, Icelandic bonds are indeed for real, at least in the sense that the government of Iceland does issue them and they do have what appear to be attractive rates. Recently, some Icelandic bonds were paying yields as high as 14.3 percent.

And it's because of these juicy payouts that some advisers have been touting these bonds. The argument goes like this: Invest in an Icelandic bond and at the very least you'll collect that fat yield during the bond's term. If the U.S. dollar continues to fall, you'll also enjoy some currency gains. In short, if everything worked out to your advantage, you might experience a double-barrelled return that could leave you saying "Ég er í sjöunda himni!" (Icelandic for, "I'm as happy as can be!")

But what if the currency works against you? Let's say, just for the purposes of an example, that you wanted to invest your $20,000 in an Icelandic bond paying 13 percent for one year.

To do that, you (or, as a practical matter, your brokerage firm) would convert your dollars to Icelandic Krona. At the recent exchange rate of 59.4 Icelandic Krona per U.S. dollar, you would invest 1,188,000 Krona in the bond (59.4 x 20,000). And given a 13 percent yield, you would have 1,342,440 Krona at the end of a year.

But what good are Krona to you unless you're planning a trip to Iceland? You've got to convert those Krona back to U.S. dollars. If over the course of the year the Krona dropped 10 percent against the dollar so that it took you, say, 66 Krona to buy one U.S. dollar, then your 1,342,440 Krona would be worth only $20,340, reducing your gain to 1.7 percent.

Currency exchange fees would probably wipe out even that gain. And if the Krona dropped 15 percent against the dollar, requiring 70 Krona to buy one U.S. dollar, then your 1,342,440 Krona would be worth $19,178 - and you would have a small loss even before transaction fees.

I'm not in the currency forecasting business. I will point out, though, that over the past two years the exchange rate has ranged anywhere from 59.1 to 80.4 Krona per dollar. (For a look at current at historical exchange rates for the Krona as well as just about any other currency that might interest you, click here.)

But I do think it's important that anyone thinking of buying foreign bonds realize that currency movements will affect the return you ultimately get. All of which suggests to me that, unless you feel you have some insight into the future direction of the Krona, putting money into Icelandic bonds is really closer to gambling than investing.

That's not to say I'm against investing in foreign securities. In fact, I'm all for it, but not just because they may be able to enhance your portfolio's long-term gains. Rather, I'm a fan of investing overseas because adding foreign investments can also lower the volatility of an all-USA portfolio for the simple reason that U.S. and foreign markets don't always move in lock-step. I also think most U.S. investors are better off investing in foreign stocks - or, more likely, foreign stock funds - than foreign bonds. The reason is that bond returns are generally lower than those on stocks, which means a swing in rates can wipe out bond returns more quickly than would be the case with stocks.

Besides, the kind of investment you're talking about here is really more of a timing bet, essentially trying to swoop in because rates happen to look particularly attractive. I believe that if you're going to do foreign investing, you should make it a core part of your portfolio - devote, say, 10 percent to 25 percent or so of your money to foreign stock funds and hold them for the long term.

Yes, those holdings will also be vulnerable to currency swings. But the ups and downs are likely to be a wash over the long term and you'll still be earning the underlying returns that come from owning shares of companies with generally rising earnings. So if you're looking to do something a bit different with your $20,000, why not try one or two of the diversified foreign stock funds on our Money 70 list of recommended funds.

If that's not exciting enough for you, you could try one of the international small-cap or emerging markets funds on the list, although I want to stress that emerging market funds in particular can be extremely volatile and should represent only a small part of your total holdings. They've also had a huge run-up lately, so you'll want to proceed with caution and don't even think of buying unless you're planning on staying in at least five years.

As for Icelandic bonds, though, I think they're too narrow and short-term a bet for most individual investors and require more knowledge of Iceland's economy and financial markets than most of us are likely to have. But then again, who knows, maybe interest in things Icelandic will blossom after Björk's 2007 North American tour.