From the February 2008 issue of Wealth Manager Web • Subscribe!

A Worldly Winner

While domestic bond funds eked out modest returns in recent months, foreign funds gained speed. During the first 10 months of 2007, world bond funds ranked as the top performing fixed-income category, returning 6.8 percent--2 percentage points ahead of domestic government funds, according to Morningstar. Higher yields abroad helped give foreign funds a boost. At a time when 10-year U.S. Treasuries yield a skimpy 4.0 percent, plenty of high-grade foreign bonds yield more than 5 percent.

Even more important than the extra yields, world funds have benefited from the dollar's slide. The price of the euro climbed from below $1.30 in January 2007 to above $1.48 in November. As the dollar slipped, the value of foreign bonds increased for U.S. investors. Is this the time to bet on further dollar declines? Perhaps. But whether or not the U.S. currency continues falling, foreign funds can offer important diversification. As recent history demonstrated, foreign bonds sometimes shine when their U.S. counterparts are struggling.

Which world bond fund makes the best choice? To find a winner, we turned again to screens developed by Donald Trone, chief executive officer of Fiduciary360, a consulting firm in Sewickley, Pa. Trone's due-diligence process seeks funds that are at least three years old and have more than $75 million in assets. One- and three-year total returns must exceed the category medians, as must five-year results if the fund is that old. Alpha and Sharpe ratios must also surpass category medians. The expense ratio must fall below the top quartile, and at least 80 percent of the fund's holdings must be consistent with the category.

The screens reduced the number of contenders from 144 to 37. Strong performers included Templeton Global Bond, AllianceBernstein Global Government Income, and American Funds Capital World Bond. But we awarded the title to Oppenheimer International Bond, which had the highest five-year performance of any finalist.

Oppenheimer topped the field by following an aggressive investing style. Portfolio manager Art Steinmetz is not shy about acting on his convictions. He often overweights countries and regions. While many world funds have limited holdings in the emerging markets, Steinmetz has maintained big stakes in developing regions such as Latin America and Eastern Europe. In addition, Oppenheimer aims to profit from currency moves. This is very different from some world bond funds which hedge their foreign currency exposure, seeking to protect shareholders from turbulence.

Oppenheimer's currency strategy has boosted returns in the past year. As the dollar dropped, the fund was exposed to the euro and other currencies. Steinmetz figures that the dollar will continue falling. With the Federal Reserve cutting interest rates, foreign bonds now yield more than comparable domestic issues. That has been encouraging investors to sell U.S. Treasuries and buy foreign bonds, a process that puts downward pressure on the dollar. "The dollar will keep falling until the Federal Reserve is in a position to hike interest rates," says Steinmetz.

When he expects the dollar to rise, Steinmetz moves accordingly. In 2005, he loaded up on emerging market bonds that were denominated in dollars. The strategy succeeded. Oppenheimer's bonds soared for several months as the dollar climbed and emerging market economies improved. Steinmetz returned 3.3 percent for the year--a strong showing in a period when the average world bond fund lost more than 3 percent.

Recently Oppenheimer has profited from stakes in the emerging markets. During the past three years, emerging market bond funds have returned 10.9 percent annually, more than double the figure for U.S. government funds. Lately Steinmetz has kept 10 percent of his assets in Brazil. The country's five-year government bonds currently yield more than 12 percent. Investors demand such a hefty payout because they fear that the country could suffer an inflation surge--a hazard for bond owners. But Steinmetz argues that the Brazilian economy is poised to enjoy a period of healthy growth with modest inflation. Once burdened by big budget deficits and foreign debts, the Brazilian government has tightened its belt, controlling spending and eliminating debts. Inflation has dropped from 12 percent in 2004 to 3 percent in 2007. "They have beaten down inflation, yet people are still worried that things could spiral out of control," says Steinmetz.

Like Brazil, other countries in Latin America and Eastern Europe have reformed their economies. Booming global trade has helped emerging countries lower their debts. That has made Steinmetz bullish on the developing regions. He now has 45 percent of assets in emerging markets--up from the fund's normal figure of 30 percent.

Another 45 percent of assets are in Eurozone countries such as France and Germany. With European bonds paying relatively high yields, Steinmetz figures that the euro will strengthen against the dollar. He also has sizable positions in Canada and Australia. Those countries have been prospering because of rising prices for their commodities. "Growing exports of commodities should help the currencies to remain strong," he says.

Steinmetz has underweighted Japan where 10-year government bonds yield only 1.42 percent. Because the country has a sluggish economy and an inflation rate of less than 1 percent, there is little chance that bond yields will climb any time soon, he says, and the yen should decline against the euro. "The Japanese economy can't really get off its knees," he says.

Instead of buying Japanese bonds, Steinmetz plans to comb other areas of the globe, seeking countries with strong currencies and fat yields. That approach has helped him to compile a winning long-term record.

Stan Luxenberg (sluxenberg1@nyc.rr.com) is a New York-based freelance business writer and a longtime regular contributor to Wealth Manager.

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