With interest rates falling in the U.S., bond investors are going overseas, hoping to improve on the paltry returns from safe U.S. investments.
The Federal Reserve has cut interest rates repeatedly to spur the economy and ease the credit crunch. After the Fed's most recent cut, on Mar. 18, the federal funds rate stands at 2.25%, down three full percentage points in six months.
Taking inflation into account, this is more like a real interest rate of 0.25%, says Christopher Dillon, a fixed-income portfolio specialist at T. Rowe Price Associates (TROW). In comparison, Brazil offers an 8.5% real yield on government debt.
Two-year U.S. Treasury bonds are yielding just 1.59%, while other supersafe investments, including bank accounts, offer pitiful returns.
That makes foreign bond funds a smart strategy, financial advisers say, and U.S. investors seem to agree. In the past month, $632 million has flowed into world bond funds, far more than any category of bond or equity fund tracked by market research outfit TrimTabs Investment Research.
The Dollar Factor
But for U.S. investors, getting big returns on foreign bonds isn't as easy as shifting all your cash into countries with high interest rates, including Brazil and Norway. There are limits to your money's ability to cross borders, and there are extra risks for investors abroad.
The biggest risk—and the largest possible benefit—is the weak U.S. dollar. From the standpoint of a U.S. investor, a falling dollar helps the value of foreign bonds, while a rising dollar—a rare sight in recent years—hurts foreign investments. In the past year, the dollar has fallen about 13% against the euro (which is now worth about $1.54) as the U.S. economy slowed down and the Fed slashed interest rates.
Many foreign bond funds have posted big returns because of the slipping dollar. "Overseas, you get quite a bit of help from more healthy economic conditions and better fiscal and monetary policies," says Paul Herbert, a senior fund analyst at Morningstar (MORN).
Unhedged foreign bond funds are great ways to profit from the falling dollar. PIMCO, for example, manages two foreign bond funds with similar holdings. The PIMCO Foreign Bond Fund (U.S. Dollar Hedged) (PFOBX) is hedged so investors aren't affected by shifts in currency values; it has risen 2.19% so far this year. However, its unhedged sibling, PIMCO Foreign Bond Fund (PFBDX), is up 9.5% since the new year.
It's possible the U.S. dollar could recover later this year, especially if the U.S. economy revives and foreign central bankers start cutting their interest rates. Currencies can be volatile and hard to predict, which is why Herbert recommends hedged foreign bond funds for investors who want to preserve their capital and avoid risk.
A Small Portion of Your Portfolio
Steven Medland of TABR Capital Management advises his clients to keep foreign bonds as a small part of their investment portfolio, but not as a bet the dollar will fall. Rather, foreign bonds give investors an effective hedge against losses elsewhere in their portfolio. If U.S. investments continue to stagnate, foreign bonds are likely to do well. "We're not in foreign bonds because we think we're going to make a quick buck," Medland says. "It's really about that diversification over a long time period."
Equity funds have multiplied so that they slice and dice the market and various regions of the world in countless ways. But there are far fewer choices for foreign bond investors. Though there are many foreign bond funds available, most take the conventional approach of spreading their investments across the globe. That tends to lower yields, but adds to their safety.
Many financial planners advise keeping foreign bonds to a small portion of your portfolio—making up about one-third of your total fixed-income holdings. Before you invest, experts recommend you look closely at a foreign bond fund's holdings, manager's strategy and past performance, and fees.
Medland recommends multisector bond funds, such as the Loomis Sayles Bond Fund (LSBRX), because they give investors international exposure along with U.S. bonds. They let their fund managers take advantage of investing opportunities wherever they see them.
Emerging-Market Exposure
Some advisers recommend adding exposure to emerging-market debt. Developing nations pay higher yields and entail more risk, but not as much risk as "Third World debt" used to imply. Many countries, like Brazil, Mexico, and China, have greatly improved their fiscal condition. "Now the lines have somewhat blurred between the emerging and developed world," T. Rowe Price's Dillon says.
Still, Cathy Pareto, president of Cathy Pareto & Associates, advises her clients to stay away from emerging-nation debt, saying it's too risky for fixed-income investing. Bonds, she says, are supposed to be safe investments that maintain their value. "If I'm going to take risk, I'm going to take it on the stock side, not the bond side," Pareto says. "It's not where you want to get wild and crazy."
Indeed, during times of great uncertainty in the world's economy and financial markets, investors probably don't want to get too fancy. But just as with any other investment, if you choose a foreign bond fund carefully, it's possible to capture more yield without taking too much risk.