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Why Foreign Bonds Make Sense For Income-Oriented Investors

Source: Wall Street Journal
By: Jennifer Levitz

It's never been easy for investment advisers to convince people that foreign-bond funds are a good bet. Typical investors have home-country bias, or a preference for Treasurys, municipal bonds and U.S.-company debt. Foreign bonds "often get a short glance," says Tom Roseen, a research manager at Lipper Inc. "People are more willing to…explore foreign-equity funds."

See the complete Investing in Funds: A Monthly Analysis report.

But with the dollar weakening and yields on U.S. Treasurys paltry, the case for adding foreign-bond exposure to a fixed-income portfolio is looking more persuasive to many investors. Dabbling in overseas bonds may provide a hedge against further weakening of the dollar—barely up after reaching its all-time low against the euro—and allow investors to take advantage of higher interest rates abroad.

Yields are markedly better even in many relatively safe countries with stable governments and economies. For instance, Australia's two-year government bond yields 4.4% versus 0.8% for a U.S. Treasury of the same maturity.

These days, the debt of some foreign governments may look safer than the bonds issued by cash-strapped U.S. cities and states.

"U.S. municipal bonds used to be synonymous with safety, but now, do you really want to have exposure to California's budget woes?" says Brad Durham, managing director of Emerging Portfolio Fund Research in Cambridge, Mass.

He says money is streaming into foreign bonds, both government and corporate, largely through U.S.-based global bond funds, which have attracted net inflows this year of $76.8 billion through October in the strongest showing since his firm began tracking the bonds in 2003.

Concerns about Dubai's fiscal strength, after a state-run company sought to delay debt payments, show that the risk of bad debt is still out there, says Arijit Dutta, a Morningstar Inc. analyst. But he expects the Dubai disruption to be a "fairly local problem" and says it's still the case that many emerging markets have improved over the past 15 years as investments. "Many of the bigger markets…Brazil, Mexico, and Russia, are way more fiscally responsible than in the past and have improved capacity to service their debt," he says.

Overall, investors "now have a sizable alternative to the domestic U.S. bond market," says Mr. Dutta. He recommends that investors keep between 10% and 40% of their fixed-income portfolio in foreign bonds.

The bigger risk for investors in foreign-bond funds is their exposure to foreign currencies. Many foreign-bond funds are "unhedged"—meaning they provide full exposure to foreign currencies—so any drop in the dollar can bolster their return. But if the dollar strengthens against the currencies a fund's holdings are denominated in, it could lead to a lower share price when the American investor cashes out in dollars.

Most of the funds aren't a good bet for anyone with strong feelings that the dollar is going to rebound. But if it does, the higher yields in foreign markets will provide some cushion.

Foreign bonds are "almost as much of a currency play" as an interest-rate play, says John Donohue, chief investment officer of global liquidity at J.P. Morgan Chase & Co. Morgan Stanley predicts the dollar in 2010 will fall to $1.60 against the euro, from about $1.50 recently before a reversal late in the year.

Says Mr. Dutta: "A lot of people expect further weakening of the dollar, so if you believe that, foreign bonds would be a good way to hedge that risk."

If you're earning a higher interest rate on a foreign bond, that will likely "mute or dampen the pain you might feel from a strengthening dollar," says Mr. Roseen of Lipper. He says that over time, "the changes in currency value will not add up to as much as you earn with the slightly higher interest rates."

Foreign-bond funds may also provide a hedge against inflation. Typically, a falling dollar coincides with rising U.S. inflation as the cost of imports, which represent a huge portion of consumer goods, rises.

"Global currency markets in some cases provide an interesting hedge to that," says Michael Hasenstab, manager since 2001 of Templeton Global Bond.

Mr. Hasenstab says when inflation worsens, global growth tends to pick up. That means more demand at a time when inflation is eroding purchasing power. In that case, he'd look to invest in debt issued by countries, such as Brazil, that "store value," such as commodities.

Investing in countries that "are closely tied to commodity cycles is one way that investors can begin to diversify their risk away from U.S. Treasurys if inflation goes up," he says.

Templeton Global Bond, which invests in the government debt of about 20 countries, returned 18% in the first 11 months of this year and is ranked third in three-year returns and first in five-year returns in its Morningstar category. The fund doesn't hold any U.S. Treasurys and hasn't "for quite some time," says Mr. Hasenstab. It does more currency hedging than many world-bond funds, but its mix of 80% government debt and 20% corporate and other types of debt is common for its category.

Lately Mr. Hasenstab has been sticking to short-duration foreign government debt to reduce the risk of losses due to rising interest rates, which drive bond prices down. Shorter-term debt prices are typically less sensitive to rate changes. The fund's top holding is South Korean short-term bonds that have been yielding about 4.5%, "versus almost zero in the U.S.," he says.

Morningstar's other picks among funds in its world-bond category include Loomis Sayles Global Bond, T. Rowe Price International Bond, and both Pimco Foreign Bond (U.S. Dollar-Hedged) and Pimco Foreign Bond (Unhedged). The Pimco unhedged fund invests in corporate debt as well as government debt.

Fidelity Investments portfolio manager John Carlson suggests that between 3% and 5% of a fixed-income portfolio be placed in emerging-market bonds.

Mr. Carlson runs Fidelity New Markets Income, an emerging-markets bond fund that recently has been adding to its investments in debt issues by the governments of Venezuela, Argentina and Russia. The fund was up 44% through November and ranked fourth in its emerging-markets bond fund category in trailing three-year returns, and second over the past five years.

Mr. Carlson says he finds many emerging countries to be "less levered" than the U.S. and growing faster.

"It's a play on global growth and sound fiscal policies," Mr. Carlson says.

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