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Diversify your portfolio -- invest globally

The stock market is in the toilet and your retirement is rapidly swirling out of sight. Your certificate of deposit is paying off with a handful of pennies. Where the heck is an investor supposed to go to get a decent return?

How about Iceland? The Icelandic government is offering treasury bonds that pay more than 8 percent.

But there's a catch: You can't buy them. Foreign government bonds are generally not for sale to private citizens in this country.

However, there is a way to get in on the act: international bond funds.

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International bond funds
Bond purchases have exploded in the past year or so as millions of investors make the proverbial flight to safety from the imploding stock market. But it's an easy bet that most Americans are plowing their money mainly into Uncle Sam's bonds, which are just one part of the bond landscape.

International bond funds can be a port in the storm for investors when the U.S. economy is on shaky ground and the dollar is losing value against international currencies. Some international bond funds have raked in returns of 14 percent or better year-to-date.

"Over time there are periods when foreign bonds outperform domestic bonds and there are other times when the reverse is true. There are opportunities to add value by holding foreign bonds," says Aran Gordon, fixed income portfolio manager at T. Rowe Price.

"For quite a number of years, the foreign bond market has played second fiddle. We've had strong currency in the United States, a strong growth engine. We're seeing that unravel and it's reflected in terms of the dollar's strength."

Your returns from an international bond fund come not only from the bonds themselves but also from currency fluctuations, says Morningstar senior analyst Bridget Hughes.

"The dollar has been weak and it's a tailwind for international asset returns, including international bonds. When you convert the foreign currency back into U.S. dollars, you can buy more dollars.

"But currency movements can be volatile and dramatic, " says Hughes. "The dollar was strong for a long time in the 1990s, but it's been reversing course. This could be a long drawn out process or it could reverse tomorrow."

Don't worry. We're not going to say you have to monitor currency fluctuations if you want to invest in international bonds. In fact, the idea is to buy high quality funds and hold them for quite some time. When your U.S. investments are going south, those international bonds may dampen the volatility in your portfolio.

"Don't do this if you're planning to cash out in five years. That's too close in. This is for people with a much longer time horizon, a minimum of 10 years out. Then the allocation in international bonds, mostly European, makes a lot of sense," says Andrew Clark, senior research analyst at Lipper.

International bonds funds are as varied as U.S. bond funds. You can buy funds holding government or corporate bonds, or a mix of them, from just about any country. Or, you can buy a basket of corporate and government bonds from a range of countries.

Calculated risks
If you're willing to take on some risk, you might opt for bonds from emerging markets, which could include China, Russia, South Korea or Peru.

Emerging market debt has been the highest performing asset class over the last 10 years, according to Gordon.

"But it's so volatile, it's not supposed to be a main source of returns. It should have a low correlation with other asset classes you're investing in. But from a returns standpoint, it's worth looking at."

Just as with American bond funds, there are risks. A rise in interest rates will bring down the price of an international bond fund. And a drop in the value of the foreign currency can also affect international funds.

Another concern is a political or economic crisis could lead a country to default on its debt obligations. Standard & Poor's says 28 sovereign governments are in default on bonds and bank loans, and the number is rising.

Dan Moisand, a certified financial planner with Optimum Financial Group in Melbourne, Fla., advises sticking with top-name funds.

"Across the board, with fixed income we prefer very high credit quality -- government and corporate. Generally, keep the duration short to intermediate. We're not using bonds to speculate on interest rate changes; we want stability. Expenses should be low, the fund should be of some size and it should be run by a firm that's been in the overseas arena for some time."

Safer bets
Hedging is another consideration. If you have a low risk tolerance, or you're investing in a foreign fund for steady income, you'll want the fund to be hedged. Details about whether the fund is hedged completely, partially or not at all can be found in the prospectus.

"Hedging is an additional expense the fund incurs to get rid of fluctuations caused by changes in the relative currency rates," Moisand says. "If you're looking at a foreign bond fund that produces high double-digit returns, chances are it's not hedged. You're getting returns from the bond fund and an additional return because the dollar is declining.

"You don't want to make a currency bet. If it goes in the other direction and the dollar increases, even if you own a portfolio of government bonds, you can still lose money. If you're looking for foreign bonds to complement American bonds, it better be hedged."

On the other hand, if you're not looking for a stable income fund and you want to maximize returns, you don't want the fund to be hedged.

"Some funds alleviate volatility by hedging the foreign currency back into U.S. dollars so everything is in dollars. They're hoping to gain a pure bond return, and if the dollar is strong, you're holding dollars. But we're not in an optimal scenario where a fully hedged fund makes the most sense," Gordon says.

"If we have a situation where the U.S. dollar is somewhat vulnerable, the Euro may be a better opportunity. The point is; hedging back into dollars threatens one of the major benefits."

Gordon says the T. Rowe Price International Bond Fund (RPIBX), has a mandate to not hedge into dollars. The fund will cross hedge into Euros or other foreign currencies when it's beneficial.

Rich Taylor, fixed income client portfolio manager at American Century, says about 2 percent of the American Century International Bond Fund (BEGBX) is hedged.

"This is more a play on non-dollar currencies and non-dollar bond markets around the world. It's very high credit quality."

As always, it's best not to try this on your own. Funds that have fabulous returns this year may sink next year. It's well worth the money to talk to a financial planner who has expertise in international funds before making any moves.

While international bond funds can add diversity and stability to your portfolio, most experts say your first priority is to diversify among American stocks, bonds and cash. After that, add 5 to 10 percent international government and corporate bonds to the mix.

-- Posted: Oct. 14, 2001

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See Also
Stock market killing your life insurance?
FAQ about 401(k) accounts
Diversification, planners and brokers
Investing glossary
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