Foreign Bonds Can Pay Well, but They’re Risky

You’ve noticed how interest rates have risen in Europe and Japan amid the euphoria of the opening of the East Bloc. You figure that overseas bond yields must look attractive. What can you do to capitalize?

If you’re willing to take some risk, you might consider mutual funds investing in foreign bonds.

International bond funds invest in bonds issued by governments of such countries as Japan, West Germany and Britain. Global funds also invest in U.S. bonds.

Yields on their bonds have risen in part because of rising inflation expectations. For example, yields on West German government bonds have jumped due to concerns about the inflationary impact of reunification. Accordingly, German bonds now yield about 9%, higher than comparable U.S. bonds for the first time in decades.

Likewise, inflation concerns in Japan have pushed government bonds there close to 7%. And after adjusting for inflation, “real” yields on many European bonds are higher than on U.S. bonds.

And with strong demand for capital to finance reconstruction in Eastern Europe, foreign bond rates may stay high for awhile.

But while foreign bonds look like a great buying opportunity, they’re not a sure bet. They are definitely not for the fainthearted.

That is because there is more to making money in international bond funds than just capitalizing on high yields. As with U.S. bonds, you have to worry about the direction of interest rates. If rates rise further, the values of bonds fall.

Also with foreign bonds, you must worry about fluctuating currency values. If the dollar rises, values of bonds denominated in foreign currencies will fall. Indeed, investing in foreign bonds is really a play on the dollar, experts say.

So if both the dollar and foreign interest rates rise, you’ll be hit with a double whammy. That could easily wipe out interest earnings.

But if the dollar and interest rates fall, you could make a nice return. That’s what happened in 1987, when international and global funds gained 20.87%, according to Lipper Analytical Services. Some funds gained far more.

Thus, “when you buy an international bond fund, you are relying on the market timing capability of the portfolio manager,” says Catherine Gillis, senior analyst at Morningstar, a Chicago firm that tracks fund performance. That means that they are not ideal as long-term, buy-and-hold investments. “You might get lucky, but if you are investing for the long term, you want to be more than lucky.”

Those risks acknowledged, investors may still do well by putting a fraction of their portfolio into these funds.

The dollar has risen recently against the Japanese yen while declining against the German mark; overall, it may very well weaken soon. Foreign central banks are trying to drive the dollar down. And the U.S. government, to encourage exports, may concur.

“We think the dollar is peaking,” says William E. Donoghue, publisher of Donoghue’s Moneyletter of Holliston, Mass.

Some experts also think that the recent rises in foreign interest rates have been overdone. That’s also bullish for foreign bond funds.

Another argument for the funds is the fact that they haven’t done all that well as a group the past couple years, rising only 4.60% in the past 12 months and falling 2.05% so far this year. Fund groups often follow cycles, rebounding after poor showings.

Donoghue picks Scudder International Bond Fund (800/225-2470), up 7.02% the past year; Fidelity Global Fund (800/544-6666), up 7.58%, and T. Rowe Price International Bond Fund (800/638-5660), down 2.11%.

To reduce your risk somewhat, consider global funds such as Fidelity Global. The ability to invest in U.S. bonds as well gives them more flexibility.