From the December 2007 issue of Wealth Manager Web • Subscribe!

Bond World

Stocks and bonds, bonds and stocks. Asset allocation starts with this fundamental mix, and for good reason. Low correlation prevails between the two asset classes--and for enduring economic reasons. No wonder that adding bond exposure to a portfolio of stocks usually brings superior risk-adjusted expected returns compared to owning either asset alone.

Investors generally accept the logic of the stock/bond diversification, and many extend the strategy to foreign equities. Bond allocations, by contrast, favor the domestic market. "People tend to have a home bias," says Christopher Lazzaro, vice president of financial advisor relations at Boston money manager Loomis Sayles & Co.

History, however, suggests the home bias is a mistake. The diversification benefits of foreign bonds are potent, or at least they have been in the past. Non-U.S. debt securities post low trailing correlations with most of the major asset classes, including U.S. and foreign stocks, commodities and REITs. Foreign bonds also move with a fair degree of independence against U.S. bonds. The basic reason is that economic and inflation cycles--the driving forces of bond returns--vary quite a bit from nation to nation and region to region.

That's good news since finding asset classes with low correlations is job one for building superior portfolios on a risk-adjusted basis. By that standard, there's a strong case for owning foreign bonds in a diversified portfolio. Yet the asset class is largely ignored by U.S. investors, or so it appears based on mutual fund assets.

Morningstar's world bond and emerging markets bond categories for open-end funds collectively held $72 billion as of this past August, a fraction of the $1.5 trillion for international equity funds. ETFs add another $3 billion to the foreign debt space. That's mostly in currency funds, although the first foreign bond ETFs were launched in October. The SPDR Lehman International Treasury Bond (Amex: BWX) targets non-U.S. investment-grade government debt. Another October arrival wass PowerShares Emerging Markets Sovereign Debt ETF (Amex: PCY), which focuses on bonds issued in the developing world.

For the moment, however, publicly traded funds in the offshore bond space are still a drop in what is a very large asset class bucket. Let's be generous and say that foreign bond mutual funds and ETFs add up to $100 billion. That still looks like a rounding error in a world of $20 trillion of outstanding non-U.S. debt securities with maturities of one-year or more as of this past March, according to the Bank for International Settlements.

Investors who adopted a bond allocation prescribed by the share of non-U.S. bond issuance would have a fixed-income mix of 53 percent foreign and 47 percent domestic. It's a safe assumption that relatively few U.S. investors follow Mr. Market's instructions to that degree. One reason, suggests Morningstar analyst Michael Breen, is that foreign bonds don't resonate with retail investors compared to foreign stocks. "There are several different layers to the [foreign bond] onion and it's an esoteric onion to begin with."

The layers include foreign currencies, sovereign versus corporate debt, and emerging market versus developed market. Yes, overseas equities are complicated too, although Breen reasons that investors are more comfortable with stocks generally. To the extent that they need or want bonds, Treasuries and domestic corporates are widely considered adequate. Foreign debt, as a result, is minimized if not ignored outright.

The myopia has come at the price of a sizable opportunity cost in the past. Consider the Foreign Affairs table at left, which compares the trailing three-year correlations of the major asset classes. Clearly, foreign bonds have packed a diversification punch across the asset class spectrum.

In recent years, Citi Non-$ World Government Bond Index's returns (in unhedged dollar terms) had no correlation with U.S. stocks (S&P 500) and low correlation with foreign equities (MSCI EAFE) and commodities (DJ-AIG Commodity), according to Morningstar Principia. Perhaps more remarkable is the fact that foreign government bonds also displayed low correlation with U.S. bonds (Lehman U.S. Aggregate). The lesson is that domestic fixed income is no substitute for foreign bonds.

As a subset of foreign bonds, emerging market debt is a potent diversifier, too. The Citi ESBI Capped Brady (a benchmark for developing nation bonds) posted low to near zero correlations with the major asset classes for the three years through this past August. And if you think that emerging market bonds are just a stand-in for emerging market stocks, think again: Correlations have also been low between those two corners of the capital markets.

While the case for foreign bonds as a strategic holding is compelling on paper, it's a bit more complicated in practice. One reason is that this corner of the global capital markets pie is still dominated by active management. That may be changing, as the new foreign bond ETFs suggest. But for the moment, indexing is the exception, which for many means choosing an active manager.

Alas, the active choices are limited. Morningstar Principia lists just 83 world bond mutual funds and 25 emerging market bond funds (based on distinct portfolios excluding share classes). If you restrict the list to funds with at least five years of history, the population drops to 70 funds for both categories.

Meanwhile, bonds generally are considered the calmer asset class next to stocks. But there's a wide band of results in this corner. Recent three-year annualized returns for foreign bond funds varied by 1,000 basis points from best to worst. In short, manager skill counts a lot! (For the leading foreign bond funds ranked by Sharpe ratios, see the table above right.)

Foreign currency is also a critical factor in foreign bond funds. This is true for foreign equity funds, of course, although-- for good or ill--currency has the potential to be a bigger influence for overseas debt securities. Bonds generally have lower expected returns than equities, which is another way of saying that bonds have fewer opportunities for overcoming any foreign exchange-related losses. That's especially true for foreign government debt in the developed world, where credit ratings tend to be higher and so volatility and returns are often relatively lower.

That leaves the question: To hedge or not to hedge the foreign currency factor? The simple answer can be reduced to another question: What's your outlook for the dollar?

There are two basic schools of thought on hedging. One recommends hedging most or all of future forex volatility. The logic is that the historical record shows forex as a performance wash over time. If the expected return of foreign currency exposure is zero, why suffer the additional short-term volatility that comes with an unhedged portfolio? In short, avoid the agony by hedging completely.

Consider the Federal Reserve's index of major currencies, which is a weighted average of the dollar's value. By that standard, the dollar has traded in a fairly tight band for the last 20 years. In fact, the Fed's major currencies index is virtually unchanged for the 12 years through this past August.

Over shorter periods, however, the dollar can be volatile. The Fed's major currencies index was down more than 30 percent as of this past August from its previous peak in February 2002.

The alternative view is that forex exposure is worthwhile because it's part of the diversification argument. Adopting that view translates into limited currency hedging, if any. That's generally how Loomis Sayles treats currencies in its global bond portfolios. Minimal currency hedging is a key driver of the diversification benefits with foreign bonds, says Lazzaro.

In fact, there's evidence for both sides of the debate. Like the old saying goes, if you torture the data long enough, it will say almost anything.

But no matter your view, there's no escaping the currency factor with foreign investing. Both hedged and unhedged choices carry an embedded forex bet when investing offshore:

a) U.S.-dollar-based investors who don't hedge will receive a currency-related performance boost when the dollar falls--or a performance drag when the buck rises.

b) Hedged investors are immune to forex, a choice that effectively gives up additional return in a period of dollar weakness. On the other hand, the hedged investor sidesteps forex losses when the dollar is strong.

A third choice effectively offers a middle way between the two extremes: targeting currencies as a separate asset class with varying levels of active management. This is an increasingly popular choice for institutional strategies that fall under the heading of global tactical asset allocation.

When it comes to mutual funds, the majority choose to hedge, but in degrees that vary widely. The shades of gray rarely go to extremes, and so it's the rare portfolio that's always fully hedged or fully unhedged.

Another issue to watch when tapping offshore bond funds: Minimizing overlap with any existing domestic fixed-income investments. Many portfolios in the world bond fund category avail themselves of U.S. fixed-income securities.

Yes, foreign bond investing adds extra layers of complexity and risk compared to domestic-only strategies. And history teaches that the superior asset allocation strategies over time tend to be the most emotionally distressing ones in the short run. Comfort has its price.

JAMES PICERNO (jpicerno@highlinemedia.com) is senior writer at Wealth Manager.

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