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U.S. Treasury-bond investors are an anxious bunch these days. They've had a great run. But most know the value of their bonds and bond funds will slide when interest rates rise again. At the same time, these investors want more than ever the steady income offered by interest-paying securities — yet many would rather not gamble on high-yield junk bonds. What to do?
Think globally. Chasing down a decent yield doesn't necessarily mean running up the risk ladder if you consider investments outside the U.S. New Zealand's 10-year government bond, for instance, yields 6%-plus and looks at least as safe as an equivalent U.S. Treasury bond that kicks off about 4%. Why? U.S. interest rates are near 44-year lows, in part because of demand for Tbonds from investors looking for safety in the face of war. As that war demand unwinds, rates will rise again in the U.S.
Meanwhile, the cost of the war is adding to a massive budget deficit, which puts further upward pressure on rates. And naturally, rates will trend higher as the economy gets on track. Bonds face few of these pressures in such places as Australia, Canada and New Zealand, where economic recovery is already priced into the bond market, and in France and Germany, where growth is so slow (and inflation-fighting governments seemingly so dedicated to keeping it that way) that further rate cuts, and bond-price gains, look likely.
The falling dollar — it's down 19% against the euro in the past 12 months — is another driver behind the recent exceptional returns of international-bond funds. These funds on average have returned 16% in the past 12 months, vs. 9% for the average U.S. government — bond fund, according to fund tracker Morningstar. In response, investors have shifted $1.5 billion into international-bond funds this year. Even if the buck stabilizes, the foreign yield advantage makes diversifying this way worthwhile, and funds are the way to do it. The relative attractiveness of any one country's bonds can shift quickly as interest rates and currencies rise and fall. With international-bond funds, which invest in the debt of foreign governments and companies, you can get diversification across countries, currencies and interest-rate cycles.
You needn't get exotic. Many blue-chip government and corporate bonds around the world yield more than Treasuries and comparable corporate bonds in the U.S. So while the benchmark Lehman Brothers U.S. Aggregate Bond Index yields just 3.9%, you can pick up 5.6% with a high-quality fund like Evergreen International Bond, which buys mostly investment-grade debt and has outperformed its peer group over one, three and five years. About half its assets are in corporate bonds.
Beware an indexing approach to international bonds. Professionals outside the mutual-fund universe often employ that strategy, which could turn up in a brokerage or money-management firm's separately managed accounts geared to wealthy clients. Indexing now calls for 18% of a global portfolio to be in the debt of Japan, which yields less than 1% and would wipe out any overall yield advantage you would gain by investing abroad. Active managers aren't going anywhere near these bonds.
Another caveat: some funds, like BlackRock International Bond, hedge aggressively against dollar strength. This helps when the buck is rising but has hurt recently. BlackRock posted above-average returns while the dollar rose in 2000 and 2001 but lagged (though it still made money) while the dollar fell last year. For a fund that never hedges, there's T. Rowe Price International Bond, which returned 22% last year (it lost 3% in 2000 and again in 2001). The middle ground: Templeton Global Bond, which hedges sparingly. It returned 20% last year and was up modestly in 2000 and 2001. The right choice depends on your risk tolerance. For now, stay with consistent winners, like the funds in the chart at left. That way, you don't have to call the dollar.
- Daniel Kadlec