Over There

Bond investors have reason to fret these days. With the Federal Reserve holding its benchmark rate at just 1 percent, short-term funds pay puny yields. The economy appears to be recovering, implying that rates are bound to rise in the next year, pushing down bond prices. Overseas, the picture is much brighter. In Australia, short-term yields are 5.25 percent; in Europe, short-term yields are 2 percent. And in some Scandinavian countries, central banks appear poised to cut rates. That would deliver capital gains to overseas bondholders and enable them to outdo U.S. counterparts.

Besides offering more appealing yields, global bond markets can pay U.S. investors an intriguing bonus in the form of currency gains. Lately the dollar has been falling, and that makes foreign bonds worth more to Americans. Currency moves helped boost world bond funds in 2003 when they returned 13.2 percent, more than eight percentage points ahead of domestic bond funds, according to Morningstar. Can the dollar keep falling? Yes, say many currency analysts. The U.S. is selling dollars to satisfy its voracious appetite for imports. Meanwhile, the Bush administration appears content to let the currency fall, a process that makes U.S. exports cheaper and helps create manufacturing jobs. “There is a very strong likelihood that foreign bonds will outperform the typical domestic intermediate-term fund this year,” says Pran Tiku, president of Peak Financial Management, a registered investment advisor in Wellesley, Mass. In portfolios of clients who can tolerate moderate risk, Tiku has put 30 percent of assets in bonds. Of the fixed-income allocation, a quarter is in foreign bonds.

While the current conditions are unusually appealing for foreign bonds, overseas issues can make interesting long-term positions because they provide diversification. Foreign bond markets rarely move in lockstep with the U.S. And many foreign markets typically provide higher yields because they present greater risks.

From A to Z

Investors seeking foreign bonds should note that the funds come in a variety of styles, ranging from extremely volatile to relatively safe. Among the tame choices are funds that invest in government debt from the developed world. Riskier funds hold shakier credits from emerging markets. While some funds make big currency bets, many portfolio managers reduce volatility by using forward contracts or other hedging techniques that eliminate exposure to risky markets.

The most dramatic moves lately have come from emerging-market funds, which have returned 18.6 percent annually for the past five years, more than 19 percentage points ahead of the S&P 500. The big numbers are the result of a massive recovery that began in the 1990s. After the financial meltdowns in Russia and Asia, emerging-market bonds collapsed. But gradually the countries tightened their belts, putting in place new economic policies that reduced trade deficits. Rising commodity prices boosted sales for countries ranging from Chile to Nigeria. One of the most dramatic recoveries occurred in Russia where climbing oil prices helped the country move from a trade deficit to a surplus. Now nearly half of the 32 countries in the J.P. Morgan Emerging Market Bond Index carry investment-grade ratings. That is a big change from the 1990s, when all emerging-market government debt was rated below investment grade.

Investors who seek a relatively steady emerging-market vehicle should consider Fidelity New Markets. The fund limits risk by emphasizing government bonds from steadier countries, like Russia and Mexico. Portfolio manager John Carlson reduces currency risks for Americans mainly by buying foreign bonds that are denominated in dollars (so, the fund isn't meant to be a hedge on a falling dollar). These dollar securities hold most of their value — even if a country's currency sinks. “You can get plenty of returns in emerging markets without placing bets on the currencies,” Carlson says.

Developed and Emerging

To hold a mix of bonds from the developed and emerging markets, try Templeton Global Bond. The fund has 30 percent of assets in emerging markets with the rest in developed countries such as France and New Zealand. Templeton prefers countries where interest rates are stable or dropping and the currency seems likely to climb. When he thinks the dollar is weak, portfolio manager Alex Calvo holds foreign-currency instruments. Lately he has been investing in bonds from South Korea and Thailand, betting their currencies will climb against the dollar. “Those countries are enjoying strong exports to China, and that will keep their currencies rising,” he says.

Another fund that takes on currency risk is Oppenheimer International Bond. Portfolio manager Ruggero de'Rossi looks for undervalued currencies. Last year he found them in the emerging markets, where the fund put 30 percent of its assets. That helped Oppenheimer return 25.9 percent for the year. After the big run, de'Rossi is growing cautious, and the fund now has only 5 percent in the emerging world. Instead, Oppenheimer is emphasizing Japan, where recent reports suggest that the sluggish economy is on the mend. “If the economy really grows, investors from around the world will put money into Japan,” says de'Rossi.

That would push up the Japanese yen — and it could also lead to higher interest rates. To stay on the safe side, Oppenheimer is buying very short-term Japanese securities. Those would rise along with the yen, but avoid big losses if rates rise.

Hedging Against the Greenback

Investors seeking limited exposure to foreign currencies may prefer Lord Abbett Global Income, which holds a mix of U.S. and overseas bonds. The fund typically has about 45 percent of its assets in dollars with the rest in foreign currencies. While Lord Abbett sometimes holds a few emerging-market bonds, the fund focuses on AAA-rated issues from the developed world. Lately, portfolio manager Jerry Lanzotti is emphasizing Europe because he believes rates may decline there. He is particularly keen on Spain. “They are running a responsible fiscal policy, while a lot of other countries are breeching their deficit targets,” he says.

If you want only top-rated debt in the developed world, consider American Century International Bond. Boasting an average credit quality of AAA, the fund holds government debt from Germany and Sweden. For all its caution, American Century does take currency risk. Lately, it has been emphasizing Europe. “Domestic demand in Europe is still weak, so we would not expect to see the kind of sharp rate increases that can hurt bonds,” says Mark Settles, a manager on the fund.

Settles is betting that the euro will keep rising against the dollar. If he is right, shareholders at American Century and other foreign funds could enjoy another year of solid returns.

Bond Funds That Invest “Over There”