From the May 2006 issue of Wealth Manager Web • Subscribe!

Le Bond du Jour

Pop quiz: Foreign bonds make up what percent of fixed-income investment opportunities worldwide?

A. 23 percent

B. 52 percent

C. More than 75 percent

D. Who cares?

The answer, per the number crunchers at T. Rowe Price, is C. But many American investors--amateur and professional alike--would likely answer D.

You'd think that its elephantine size alone would distinguish foreign fixed income as a separate and distinct asset class worthy of some serious attention and significant bucks. And yet...despite its heft, despite its deliciously low correlation to just about anything and everything, despite a broad spectrum of choices along the risk-return continuum, the asset class remains largely snubbed by American investors.

"International bonds are one of the most underutilized asset classes in the United States," says Kai Wiecking, mutual fund analyst with Morningstar. "Even many `one-stop' target retirement funds will include almost every other asset class imaginable, but no international bonds--or only a very small allocation. You've got to wonder why," says Wiecking.

Oh, to be sure, double-digit returns several years running have juiced the dollar flow to at least one subset of international fixed income--emerging-market bonds--but still, we're talking relative chump change. Morningstar currently lists over 1,500 open-ended domestic bond mutual funds as compared to 79 bond funds categorized as either international or global. Total assets for the domestic-bond group stand at approximately $1 trillion. Total assets for the international/global-bond group stand at $44 billion. Of course, the global-bond group includes a good chunk of U.S. debt along with the foreign. The truly international portion, per Morningstar: $29 billion.

In other words, the ratio between what we Americans invest in domestic bonds and what we invest in foreign bonds is somewhere in the ballpark (cricket field) of 34 to 1.

"If I had to guess, I'd say that the underutilization comes in part because bond investors on average tend to be more conservative," says Wiecking. "But I also think that financial planners, whom many people rely on for investment advice, are woefully undereducated in this area."

Of course, not all financial planners are clueless. Some have not only educated themselves, but consider international bonds an essential part of a well-manicured portfolio.

"Some of our clients have no bonds in their portfolios; others have well over half their money in bonds. Whatever the percentage, about 60 percent of that will be allocated to a world bond fund," says Frank Armstrong, principal of Investor Solutions, a fee-only shop in southern Florida with $350 million in assets under management.

Mark Willoughby, senior wealth manager with Greenbaum and Orecchio, a northern New Jersey-based fee-only firm with $235 million under management, similarly treats most of his clients to a healthy dose of international fixed income. "Our allocation into foreign bonds ranges between zero and 10 percent of a total portfolio; for the majority of our clients, however, we'll typically allocate 4 to 6 percent."

Willoughby and Armstrong arrive at a similar place from two very different directions. Armstrong sees all bonds--both foreign and domestic--as serving the same purpose, which is "to temper risk." As such, he is not willing to cope with much volatility on the bond side of his portfolio. Therefore, he looks overseas for the same high-quality and short-to-intermediate duration bonds that he looks for here in the U.S. And those bonds must be dollar-hedged to avoid currency flux. Armstrong's ultimate goal: "If real yield on similar quality and duration bonds is higher abroad than we can get here--as is sometimes, but not always the case-- then we can take advantage of that, and our clients wind up with a higher rate of return."

Willoughby also sees his bonds' primary role as that of portfolio risk-reducer. But for him, foreign bonds play a radically different role than U.S. bonds. "We're not concerned so much with volatility per se when we choose a foreign bond fund," he says. "The fund itself may be quite volatile, but as long as that volatility is uncorrelated to the rest of the portfolio, the asset class can still serve as an effective risk reduction tool." Indeed, the 10-year correlation between unhedged international bonds and the U.S bond aggregate stands at a lowly 0.6. And their correlation to stocks--both foreign and U.S., both large and small--is very close to zilch.

In light of those numbers, Willoughby, unlike Armstrong, prefers his foreign-bond funds unhedged to the dollar. And in search of handsome returns, he doesn't shy away from lower quality debt, even debt from countries that wouldn't win any gold medals for economic stability.

To meet their respective needs, Armstrong uses DFA's Five-Year Global Fixed Income Fund (DFGBX). Willoughby uses Pimco Foreign Bond, Unhedged (PFUIX), American Century International Bond (BEGBX), and Pimco Emerging Market Bond Fund (PEBIX). (See "Worldly Funds," page 72 for more detail.)

Whether you're looking to goose returns or mollify risk, or both, you may find satisfaction with a position in international bonds. Ah, but which international bonds? Do you look to England, Germany and Japan, or to Mexico, Turkey, and Brazil? Do you hedge for the dollar or let the Pounds, Euros and Yen fall where they will? And finally, do you choose one of those 79 funds listed on Morningstar, or do you look to purchase individual issues?

The final question--individual bonds or bond funds--is certainly the least controversial. "To buy individual foreign bonds with any efficiency, you're going to have to trade round lots, perhaps do some currency hedging for different countries, and make certain that each client's portfolio is well diversified. That's not going to be practical except for those few wealth managers with very many, very wealthy clients," says Matthew Gelfand, Ph.D., principal of MDG Financial Advisors, a fee-only firm based in Bethesda, Maryland.

As for whether to hedge or leave your bond funds to bob up and down with currency tides, that will depend in part on your investment philosophy. "When exposure to foreign currencies is hedged, international bonds serve primarily as a source of diversification, which can potentially enhance returns without changing the fundamental role of bonds as a source of income and an anchor against more volatile assets," says Suhail Dada, a senior VP at PIMCO and global product manager. "When exposure to foreign currency is not hedged, international bonds entail higher risk, but also significantly higher return potential."

The significantly higher return potential of which Dada speaks will manifest, of course, should the greenback tumble against other currencies--an event Dada sees as far, far more likely than the reverse. "With our current account deficit and budget deficit growing, it is very hard to see how the dollar can get much stronger," he says. "But, of course, there are never any guarantees." Indeed, in 2005 the dollar made an unexpected and surprising about-face, climbing 14.6 percent against the Euro and 15.2 percent against the Yen. As a result, the Citigroup Non-U.S. World Government Bond Index, Unhedged, returned an uninspiring -9.2 percent.

Because of such volatility, says Dada, "the decision whether or not to hedge currency exposure should depend in good part on a client's risk tolerance and return objectives." Also, a portfolio heavily laden in foreign equities or other assets more than likely already has a good dose of currency exposure--another factor to consider. Some wealth managers--such as Frank Armstrong--say they prefer to take their currency risk, and enjoy their potential currency return, on the equity side of the portfolio.

It is important to note that even fully hedged for currency, the diversification offered by international bonds is still nothing to be sneezed at. According to T. Rowe Price, a basket of international bonds dollar-hedged has historically correlated only approximately to the Lehman Bond Aggregate: 0.73 for the past 10 years. Correlation figures for the MSCI EAFE Index, the S & P 500, and the Russell 2000 are all well south of the Equator: -0.15, -0.06 and -0.16 respectively.

As to whether to invest in England or Germany, Mexico or Turkey, know that we're talking about two very different animals. Emerging-market bond funds, as you would imagine, sit rather high on the risk/return barometer. For the 10 years ended December 31, 2005, emerging market bonds, the vast majority of which are dollar-denominated sovereign bonds, have clocked an annualized return of 13 percent, with a standard deviation for the period of 14.18 percent.

"A lot of people are arguing that emerging-market debt is set up for a fall, and maybe that's so, but we're not trying to be tactical," says Willoughby. "The asset class has a modest, but permanent position in our portfolios."

PIMCO's Dada thinks that emerging-market debt, despite its long run of success, is most likely not going to take a fall, or at least not a serious fall. "The underlying fundamentals of emerging-market nations are very solid. They supply much of the world's basic commodities. Many have really cleaned financial house. And their fortunes are largely bound up with fast growing China," he says.

The much larger asset class--foreign bonds as a whole--seems bound to attract more attention from American investors over time. "Although terribly underutilized today, use of foreign fixed income has been growing, and I suspect that it will continue to do so," says Morningstar's Wiecking. "I don't think international bonds will ever become a pillar of most American investors' portfolios, but at least the asset class is starting to show up as more than a blip on the radar screen."

Russell Wild, MBA (Russell@russellwild.com), a financial journalist and a NAPFA-certified financial advisor, is the author of The Unofficial Guide to Getting a Divorce, and the forthcoming Exchange-traded Funds for Dummies (both Wiley).

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