The decision to expose an international portfolio to exchange rate risk has traditionally been seen as an independent bet on exchange rate movements, having little to do with the initial decision to invest in foreign assets. This view is valid when the values of domestic and foreign assets are independent of the exchange rate. It is not valid, however, when asset returns are closely linked to the exchange rate. For bonds in particular, the investing and hedging decisions are tied together.
Unanticipated higher inflation in the U.S. than abroad will favor foreign bonds over U.S. bonds when returns are measured in local currencies (i.e., on a hedged basis). Moreover, the superior performance of foreign bonds will be reinforced when the returns are measured in U.S. dollars (i.e., on an unhedged basis), because of the appreciation of the foreign currency against the dollar. Just this environment characterized the 1974-80 period.
An unanticipated rise in U.S. real interest rates will also favor foreign bonds on a hedged basis. On an unhedged basis, however, the superior performance of the foreign bonds will be offset by the associated depreciation of the foreign currency. This economic environment characterized the 1981-84 period.