Foreign Bonds Look Good In More Ways Than One

Interest aside, they're a hedge against a U.S. slump

As the stock market gyrated last year, many investors found a haven in U.S. Treasury bonds. Indeed, boring old government bonds had their best return since 1995. But that rally may have run its course, and the next big bond play could be overseas, especially in Europe.

International bonds are not exactly well known in the U.S., but they should be on your radar screen. Like any bond, the yield provides cushions for the downside of a diversified portfolio. Even more important, most foreign bonds are denominated in currencies considered by global economists to be undervalued relative to the dollar. Sure, you can make money from interest payments, but the real attraction in the foreign-bond play is getting a ride from appreciation of the currency. Or put it this way: You're hedging against a declining dollar and even a decline in the U.S. economy.

Remember that one currency's gain is always another's loss, and for years the greenback has been the global champ. During the past decade, foreign investors exchanged francs, marks, and yen for dollars so they could buy stocks, especially shares in fast-growing tech companies. They also bought into the U.S. Treasury market to take advantage of higher interest rates, the result of a tight monetary policy. Now that the U.S. economy is slowing and interest rates are falling, that trend has begun to reverse itself.

MOMENTUM SHIFT. For instance, as the Nasdaq sell-off accelerated during the fourth quarter, the euro started gathering steam, rising from an all-time low of 82.25 cents per euro in October to end the year at 94.24 cents. Britain's pound sterling, which fell to a 14-year low last year of $1.39, also recovered strongly. That has given international bonds a nice lift. From the October low point to the end of the year, the Salomon Brothers Non-U.S. World Government Bond Index gained 7.4%. Euro-denominated bonds more than doubled that. Despite the rally, most global bond managers think these securities remain undervalued. "A lot of the indicators of long-term value now favor the euro," says portfolio manager David Germany of MAS International Fixed-Income Fund.

Foreign-bond trading can be cumbersome and costly, so a good way to tap this market is through mutual funds. Choose carefully. The funds that performed the best in the past few years were those that hedged their foreign currency exposure. That means when the dollar strengthened, they were not hurt by the fall in the values of the euro or the yen.

Now, the game has done a 180-degree turn. The funds to own are the unhedged ones (table), which go up in value as the dollar weakens. To find out whether an international-bond fund hedges its currency exposure, you should call the fund company or read the fund's latest semiannual report. The management company will disclose if it engages in hedging strategies.

T. Rowe Price International Bond Fund, for example, doesn't hedge foreign currencies against the dollar, although it does sometimes hedge them against each other. For instance, the fund has hedged its yen exposure against the euro because management believes Europe has better growth prospects than Japan, and the euro will strengthen vs. the yen. That gives the fund all the diversification benefits of a foreign portfolio, but still allows it to take advantage of valuation discrepancies between currencies. MAS's fund employs a similar strategy. Both funds are no-load.

Two funds designed as currency hedges are the Franklin Templeton Hard Currency and Prudent Safe Harbor. Franklin invests mainly in nondollar money-market instruments. Prudent Safe Harbor buys short-term government bonds issued in other currencies. Both funds have high expense ratios, 1.35% and 1.50% respectively, and Franklin's has a 2.25% sales load.

Either way, the most important thing is that with foreign currency bonds, U.S. investors can gain protection against a weaker dollar.

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