AMERICAN investors have become quite enamored of foreign stocks in recent years, but they haven’t fallen nearly as hard for foreign bonds.
Roughly 90 percent of the money that Americans have poured into international mutual funds this year has gone into stock funds, according to AMG Data Services; as for domestic investments, Americans have put roughly 70 percent into bond funds.
Neglecting foreign bond funds may be shortsighted. Many bond experts say that a little foreign diversification can be good for the fixed-income side of a portfolio — and can help smooth out returns if there’s a decline in the dollar.
That said, some experts caution that this may not be the best time to put new money into foreign bonds. In particular, they say that investors shouldn’t expect foreign bond funds to keep outpacing domestic bond funds as much as they have so far this year.
Funds that invest in emerging-markets debt have returned more than 8 percent this year, while a broader foreign bond fund category has returned more than 4 percent. Funds that buy long-term United States Treasury issues, meanwhile, have struggled to eke out 1 percent, according to Morningstar.
“One reason that foreign bonds have outperformed over the last year is because the Fed was raising rates while other countries were not,” said John Donohue, the chief investment officer in the fixed-income group of J. P. Morgan Asset Management.
Bond prices fall when interest rates rise. Mr. Donohue predicts that Treasuries will fare better than foreign bonds next year, on an absolute basis, because the Federal Reserve will start cutting rates. But he says he thinks that the dollar will fall against other currencies, which would benefit Americans who hold some foreign bonds denominated in those currencies — for example, in an unhedged foreign bond fund.
That view of interest rates and the dollar is becoming fairly common among bond experts.
“We think the U.S. economy is going to slow, and inflation pressure is going to subside,” said Martin J. Mauro, the fixed-income strategist at Merrill Lynch. Mr. Mauro said he thought that the Federal Reserve would cut its benchmark short-term interest rate to around 4 percent by the end of 2007, from its current 5.25 percent.
On the other hand, Mr. Mauro said he expected British and European central bankers to raise rates next year. While he is cautious about bonds from other developed countries, he said the risks were far greater for emerging-markets bonds, which have soared in recent years. He said investors were now being paid very little extra interest for owning emerging-markets bonds, compared with United States Treasuries. On average, he said that the difference was only 1.85 percentage points; four years ago, the emerging-markets bonds were paying 8 points more than Treasuries.
“If there should be any slowdown in global economies,” Mr. Mauro said, “emerging markets would suffer the most.”
The outlook for foreign interest rates is only one part of the picture. Foreign currency markets can have a much stronger impact on foreign bond funds, which generally come in two varieties with respect to currencies. They are either hedged — eliminating the risk of foreign currency markets — or not hedged. If you invest in a hedged fund, you have to worry only about the relative interest rates in the countries where it invests. But keep in mind that the dollar’s slide this year was responsible for a large part of the gains in unhedged foreign bond funds.
Consider Pimco, which specializes in fixed-income portfolios and has both hedged and unhedged foreign bond funds. Sudi Mariappa, who manages both the Pimco Foreign Bond (U.S. Dollar Hedged) fund and the Pimco Foreign Bond (U.S. Dollar Unhedged) fund, says that the two portfolios aren’t clones, but that they have very similar holdings. This year through Thursday, the unhedged foreign bond fund returned 5.3 percent while the hedged foreign bond fund returned 2.6 percent.
The unhedged fund started trading in 2005. But Mr. Mariappa has managed its hedged cousin since 2000, with average annual returns of 4.5 percent over the last five years. Both funds yield more than 2.5 percent and have expense ratios of 0.95 percent.
Mr. Mariappa said that there was now a stronger case for unhedged foreign bond funds, because of a weak outlook for the dollar, but he thought that Treasuries might outperform foreign bonds on an absolute basis next year.
“We expect U.S. rates to fall more than foreign rates,” he said, “so you’ll get a bigger capital gain by holding U.S. bonds.”
Ian Kelson, who manages the T. Rowe Price International Bond fund, says that his fund never has exposure to the dollar, but that he will hedge one foreign currency against another. For example, he says he thinks that the Japanese yen is very cheap now, and that he expects it to rise against the dollar. But he also expects Japanese central bankers to raise interest rates. So he has lightened up on Japanese bonds, while emphasizing the yen.
T. Rowe Price International Bond, which Mr. Kelson has managed since 2000, has had average annual returns of 8.3 percent over the last five years; so far this year, it has returned 6 percent. The fund yields 3.1 percent and charges 0.86 percent in annual expenses.
Investment strategists usually recommend holding most types of bonds in tax-deferred accounts, because taxes on the bonds’ interest are usually higher than taxes on dividends from stocks. The main exceptions to this general rule are municipal bonds, which should be held in taxable accounts because they receive favorable tax treatment.
Some strategists advise against any investment in an unhedged fund if you will need the money within a year or two. That is because a short-term spike in the dollar could easily wipe out the interest earned.
FINALLY, if you are interested only in shielding your portfolio from a decline in the dollar, you can opt for one of the relatively new foreign currency exchange-traded funds, or E.T.F.’s. These provide direct exposure to foreign currencies like the euro, the British pound or the Swedish krona. They are basically money market accounts that are held in each currency, so they do not have the interest-rate risk of longer-duration bonds in those currencies.
But Mr. Donohue of J. P. Morgan warns that investing in a specific foreign currency is not for the faint of heart. He said that investors who didn’t own any foreign bonds or foreign currencies might want to put 5 to 10 percent of their fixed-income portfolio into an unhedged foreign bond fund that invests in developed markets, and that this would probably be a lot less jarring than owning a single-currency E.T.F.
“Currency is a very volatile asset class,” he said. “If you’re wrong you can get really smoked.”
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