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I was recently visiting a developing country and noticed that their interest rates are very high — ~15% with government bonds promising ~13% annually. I was just thinking, if the bid ask spread for that currency with the USD is B/A respectively, then what is stopping people from having B/A x (1+13%)-1 annual USD returns, which roughly turned out to be 8%?

8% for fixed income in USD is very high, but I don’t quite see the problem in my argument — assuming the currency value with respect to USD stays stable in that year.

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    "assuming the currency value with respect to Usd stays stable". But is that a valid assumption?
    – RonJohn
    Commented Aug 25, 2019 at 19:41
  • Nitpick: Your use of B/A assumes the holding period is exactly 1 year. If it were shorter, then B/A would have a greater effect on annualized return, and vice versa.
    – nanoman
    Commented Aug 25, 2019 at 20:47
  • At that point, you are basically just doing long forex trading with a margin which is not low-risk. Imagine, for example, in the last year you had held bonds in EUR, GPB, or RMB with debts held in USD: none of these currencies are from "developing" countries and all of them fell against the dollar. As with any other trading, you can get "lucky" or you can lose it.
    – Aaron Butacov
    Commented Aug 26, 2019 at 14:48
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    There's also the very real risk that a country like you're describing may go up in flames the next time a colonel with ambitions decides that he'd like to give the orders instead of taking them.
    – Valorum
    Commented Aug 26, 2019 at 19:38
  • You can try Argentina, right now you can get a GIC at 60%. Personally, I would only take it at gun-point.
    – Martin Argerami
    Commented Aug 27, 2019 at 17:55

8 Answers 8

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assuming the currency value with respect to USD stays stable in that year.

This is where your analysis breaks down. The fact that the foreign bond pays a higher interest rate indicates that the currency will weaken relative to the dollar over the year, otherwise many investors would buy these bonds as an arbitrage opportunity, driving the price up (and yield down) to match USD bonds.

In theory, the interest rate of risk-free (i.e. government) bonds should reflect the inflation expectations over that period. So governments bonds that offer high interest-rates in their own currency indicate that inflation is expected to be high over that period, and buying them over the USD should be roughly a wash. That means that if you buy these bonds, you'll earn a high interest rate, but when you exchange them back to dollars you should expect to get roughly the same return as if you bought US bonds.

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    An easy way to check this is if the country has current bonds in the market denominated in other currencies. For example, let's say Country X has current bonds denominated in their native currency, as well as others denominated in USD. The native-currency bonds return 13%, while the USD-denominated ones return, say, 4%. Now consider what this tells you.
    – user
    Commented Aug 26, 2019 at 11:51
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    Government bonds are not necessarily risk-free, however. See Argentina for a particularly messy example.
    – Kevin
    Commented Aug 27, 2019 at 16:27
  • A good demonstration is to look at the exchange rates over time of Argentina, Brazil and Turkey. Then think whether the interest rate differential is worth it ;)
    – TomTom
    Commented Aug 28, 2019 at 4:56
  • if you buy these bonds, you'll earn a high interest rate, but when you exchange them back to dollars you should expect to get roughly the same return as if you bought US bonds. No, that's just wrong. Higher risk means you should expect that you might come out further ahead than if you bought US bonds but it also means that you should expect that you might come out behind. The risk is greater - the outcome is less certain with more potential upside and more potential downside.
    – J...
    Commented Aug 28, 2019 at 12:08
  • @J... I was illustrating the expected case. Certainly higher returns mean a wider range of possible outcomes (higher risk).
    – D Stanley
    Commented Aug 28, 2019 at 13:15
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Because currency risk is not the only risk in this scenario. The risk of the developing country (the state) not servicing their obligations are the bigger risk, hence the very high interest rates.

Think of it as investing in High Yield bonds (junk bonds) - interest is high because risk is high.

Rating agencies rate countries (like they do corporations) for this exact reason.

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    This answer might apply for developing country bonds denominated in major currencies. But OP seems to refer to the local currency, of which the country is the sovereign issuer. Thus, it seems more likely that the country would resort to "printing money" to pay off bonds, rather than default outright. This takes the problem back to currency risk.
    – nanoman
    Commented Aug 25, 2019 at 20:45
  • @nanoman but currency risk can be negated or close to eliminated by various financial instruments.
    – ssn
    Commented Aug 25, 2019 at 21:07
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    Currency hedging is not free; it generally costs the difference in the sovereign interest rates. Eliminating currency risk also eliminates the excess return.
    – nanoman
    Commented Aug 25, 2019 at 21:58
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The other answers are correct, but I would like to explain the problem from a different perspective:

When some scheme seems to offer you free money for nothing, then you should always ask yourself why someone offers you that scheme. Why would a foreign government offer you to give them a loan with a high interest rate when they could just as well give you a lower one? Why do some governments have to offer interest rates like 13% when others can get away with loaning money for zero interest or even negative interest? If they could they would, but for some reason nobody wants to offer them loans if they would promise less than 13%. Why did the market decide that it would be foolish to lend that country money at a lower interst rate? Likely because:

  • The country is politically unstable. The next government might not be willing to recognize the financial obligations of the previous one.
  • The country is financially unstable. It might go bankrupt and default on its debt. That means that they decide they would rather not pay out their bonds. Don't like it? Sue them. In their court. Which is not as independent from the government as you might be used to.
  • The country is economically unstable. They have a risk of a high inflation. So if your bonds pay out in local currency, then you might end up with a lot of money which isn't worth the paper it's printed on. This is of course only a risk for bonds which are denoted in local currency. Some developing countries are aware of the instability of their currency and give out bonds denoted in reserve currencies, but not all do. Read the fine print!
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    The whole point of going bankrupt is to not have to pay out such debts, and at least in the US, you can't sue the federal government unless the government explicitly passes a law permitting people to sue it for the reason, which would defeat the purpose of bankruptcy. I'd say if any country defaults on its bonds, the courts aren't going to permit you to sue them over the matter.
    – prosfilaes
    Commented Aug 27, 2019 at 14:53
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    @prosfilaes That's generally correct if the bonds are issued under the domestic laws of the issuing sovereign. However, countries with a history of sovereign default find it impossible to issue debt under their own laws, and end up having to issue debt in foreign jurisdictions where creditors are protected from arbitrary legislation to prevent payout. This was the case, for example, with Argentina, which was forced to issue bonds under New York law, and has been struggling to negotiate restructuring for years.
    – David
    Commented Aug 27, 2019 at 21:29
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Their interests rates are not high because the borrowers are stupid. They are high because they have a lot of inflation, so the 1 billion simoleons you borrow today is worth a lot more than the 1 billion you pay back in 1 year. For the lender to break even, you must also pay for the inflation on top of default risk. This is actually the case everywhere, but in developed countries the inflation rate is so low that for everyday borrowing the effect is negligible.

In your example, the exchange rate will rapidly fall (because the simoleons are losing value faster than the dollar) and you will "unexpectedly" lose money. Moreover, there may be special laws governing currency exchange, such as taxes or capital controls, that will interfere with your business. Not to mention having to account for higher levels of crime and corruption. All of these problems drive up costs, which is why the interest must be higher to support a positive profit margin.

However, you don't need to do any forex shuffling if you want to lend in foreign countries. You can often buy their bonds directly through your broker without having to do any currency exchange. Or, you can buy funds that hold the bonds for you. The rates are higher, but the risks are also higher - it is actually not unheard of for developing countries to not meet their financial obligations. Generally the market is also weaker and more unpredictable.

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IMHO, this is a bad idea unless you understand the economy of the country you mentioned. No two country is the same when coming to similar high bank interest rates. There is a chance that the currency inflation and bad exchange rates may wipe out your interest gain.

A country exchange rate is highly dependent on the country currency flow, i.e. Foreign direct investment , foreign debt interest payout and export earning.

The only factor that a government CANNOT control is the willingness of the company that making money from export to bring the money back to the home country. High-interest rate is a favourable monetary policy to lure the offshore forex earning going back to the country. In addition, high interest also makes those export company leveraging using bank loan too expensive. Nevertheless, it is a double edge sword that will hurt or even kill the small company, which may cause many people losing their job.

So whether putting fixed-deposit or buying the local currency bond, you must watch out whether the government enact other sustainable policies to prevent the job market meltdown. Otherwise, more inflation will happen and that will wipe out all your interest earned.

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What you are describing is called Interest Rate Parity but without considering your fx risk (after earning interest in the foreign currency will I be able to buy the domestic currency back at the same rate). However you can remove the fx risk with a forward fx swap.

https://en.wikipedia.org/wiki/Interest_rate_parity

Arbitrageurs can use covered-interest rate parity to make a risk free profit by borrowing under cheaper rates, converting at today's exchange rate, then buying a bond at higher rates, then finally entering an fx forward to guarantee their rate for when the bond matures.

However this trade ties up a lot of regulatory capital and so is not done so much now. http://faculty.chicagobooth.edu/workshops/finance/pdf/Verdelhan_Deviations.pdf

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Nothing, and that’s exactly what’s happening

For example, nonresidents hold about 2B USD worth of Ukrainian bonds denominated in UAH which yield about 16%.[1][2] (in Ukrainian)

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    16% doesn't get you very far when the inflation history for the past 20 years looks like this: en.wikipedia.org/wiki/Ukrainian_hryvnia#/media/…
    – lambshaanxy
    Commented Aug 27, 2019 at 2:49
  • @jpatokal That’s as true as the fact that between 2019-01-01 and 2019-08-01 UAH outperformed every single other currency in terms of growth relative to USD. But that’s irrelevant. The OP has asked a specific question, and the answer is that people are doing exactly what the OP described without anything stopping them. What exactly the risks are and whether the reward is worth it is an entirely different question.
    – Roman Odaisky
    Commented Aug 27, 2019 at 11:41
  • @jpatokal Don't confuse currency rate fluctuations (which your linked chart shows) with inflation. They can be related, but need not be.
    – user
    Commented Aug 27, 2019 at 13:20
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Excellent answers all - one basis to add . Risk Reward ratio - the point is (as explained above ) when someone is “paying” or “asking” a premium there is a counter bargain . Essentially when a party is assuming risk they ask for a premium . And then they asking you to assume risk then they are paying you a premium ( like the example cited ) . Search for the extra risk for all such cases . Weaker political economic jurisdictions often pay such premiums ( as in higher bond rates etc) .

All these are pointed in the earlier answers , I just wanted to add the risk - premium but to it .

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