The Grass Is Greener Over There

Foreign debt issues are set to outdo their U.S. rivals

In the far riskier world after September 11, it's hard to figure out how to keep your investments growing--and safe. One strategy has a lot of merit: shifting some assets into foreign bonds.

Many Wall Street bond gurus believe foreign bonds are poised to outperform their U.S. counterparts. Also, the long-robust dollar is weakening, which will benefit U.S. investors in foreign securities. And of course, spreading your investment bets cuts portfolio risk over the long haul. "Now is the time to embrace portfolio globalization," says Jack Malvey, chief global fixed-income strategist at Lehman Brothers.

So you might consider stashing up to 10% of your investments in foreign bonds, says Mary Erdoes, head of fixed-income investing at J.P. Morgan Private Bank. The easy way is through a mutual fund, which allows you to invest in a mix of bonds from different countries for as little as $1,000. To buy individual issues, you'll need deep pockets and a broker, since these bonds trade in lots of $1 million or more. Banks and brokerage firms, however, can act as wholesalers and arrange for their high-net-worth clients to buy the bonds in $100,000 lots. Erdoes advises against this strategy unless you have at least $500,000 to invest, so you can reduce risk by owning a couple of issues.

Whichever approach you pick, foreign bonds will help smooth out your portfolio's returns, because they have a low correlation with U.S. stocks and bonds. That seems surprising, since by themselves foreign bonds are more volatile than U.S. debt. But if you had added some foreign bonds to your investment mix over the past 16 years, you would have enjoyed higher returns with less volatility. A portfolio invested 60% in the Standard & Poor's 500-stock index and 40% in intermediate-term U.S. government bonds from January, 1985, through September, 2001, would have earned an average 12.59% annually, says Ibbotson Associates, a Chicago investment consulting firm. Alter the mix--10% in foreign bonds, 30% in U.S. debt--and the return rises to 12.79%. The more diversified portfolio is also less volatile.

Foreign bonds would have boosted your portfolio's performance even though U.S. government bonds in recent years have posted the best returns worldwide (climbing 13.5% in 2000, and 9.1% this year through Oct. 29). But now, European issues especially are set to outshine their U.S. counterparts. Both intermediate-term U.S. and European government bonds currently yield around 4.5%. European bonds, however, could enjoy more price appreciation than U.S. debt securities as European central bankers make relatively deeper rates cuts to spur their economies, says Lehman's Malvey. He also likes the government bonds of Canada and Australia because they yield about half a percentage point more than U.S. Treasuries.

RISKING IT. Then there's the extra kick from currency appreciation. Michael Cosgrove of Econoclast, a Dallas investment firm, expects the greenback to weaken 15% to 20% against the euro, as well as the Canadian and Australian currencies, in the next three to four years. His reasoning: Foreign investors, who have flocked to U.S. markets in recent years, will shift some money to other nations as their economic prospects brighten.

If you opt to go the mutual-fund route, choose carefully. You'll want to look among international bond funds (vs. emerging markets funds) to get European bond exposure. But many put up to half their assets in U.S. debt securities and also hedge currency risk. As a result, you won't get the diversification you're looking for. The problem is, few funds invest solely in foreign debt without hedging currency risk (table).

To most people, foreign-bond investing is unfamiliar territory. But an overseas foray could yield richer returns.

By Susan Scherreik

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