Products That Tap Lucrative Non-U.S. Bonds

Here’s a Scandinavian number that might warm your blood: 10% yields in short-term Danish government bonds.

While lower interest rates have people in the United States searching hard for higher payouts, several other countries continue to offer rich bond market returns.

If you can tolerate risk, the current economic environment might be a good time to venture into foreign bonds. Mutual funds offer a good way to do so, since they’re diversified and professionally managed.

At the moment, U.S. yields are in the lower half of the global spectrum. There’s better potential for interest-rate cuts in European markets, some bond analysts say, because the United States appears on the road to recovery while other industrial nations have become bogged down in their own economic slumps.

As a rule, interest rates drop during the latter stages of recessions as economic activity slows and central banks resort to stimulative measures.

If European rates eventually come down, bond investors stand to reap some nice capital gains. In the meantime, they earn attractive yields.

“European bond markets currently have very high short-term rates,” says Helmuth Saurer, a member of the management committee of Switzerland’s Bank Julius Baer. “We expect short-term rates to go much lower, possibly in the second half of 1992.”

Saurer points out that with short-term U.S. yields as low as 3.5% to 4% and inflation running about 3%, Americans are earning as little as 1% in “real” returns.

That compares to nominal short-term yields of about 9.75% or more and real returns as high as 6% in some European markets, he says.

In Denmark, where rates on benchmark three-month government securities are hovering near 10%, the real returns exceed 7%, says Margaret Craddock, manager of the Scudder Short-Term Global Income Fund, headquartered in Boston.

“With low current U.S. yields, dollar-based investors don’t have the luxury of remaining unaware of the higher rates elsewhere,” she says.

Besides, spreading some of your bond holdings into foreign funds makes sense for diversification purposes. “Diversification adds to your overall return if you take a long-term perspective,” says Saurer.

Based on past results, he says, a 30% foreign-bond exposure can be expected to increase fixed-income returns by 1.5% a year over time, with lower volatility.

Bond portfolios with international holdings make up only about 6% of the $464 billion invested in all types of U.S.-based, fixed-income funds. Yet their assets have risen 80% the past year.

“I think investors understand that yields are higher overseas and that there are opportunities outside the U.S.,” says F. Brian Cerini, president of the Great Western Sierra Short-Term Global Government Fund, based in Los Angeles.

All bond portfolios with foreign holdings face some degree of currency risk--the danger that a rising dollar will reduce the value of the non-U.S. investments. “Currency risk can wipe out any potential capital gains caused by declining interest rates and offset much of the interest income,” says Rao Chalasani, chief investment officer at Kemper Securities in Chicago.

On the other hand, a falling dollar will tend to boost the value of foreign bonds, resulting in profit for the U.S. funds that own them. But many fixed-income investors would rather not take the chance, which explains the growing popularity of the short-term global products. These funds seek price stability by focusing on bonds maturing in one to three years or less, which minimizes interest-rate risk.

They also use hedging strategies to reduce most of the currency fluctuations. Great Western’s fund, for instance, has stayed within $2.48 to $2.51 a share since its inception in February and now yields about 8.3%.

Anyone with a more aggressive outlook might consider funds that hold longer-term foreign bonds, which aren’t hedged and have the potential to earn bigger gains or losses. These portfolios have done well as a group, posting a total return of 79% on average from 1987 through 1991, according to Morningstar Mutual Funds, a Chicago research publication.

The short-term products returned 6.4% on average in 1991, the only full year for which most were up and running. (Total returns include both interest income and capital gains or losses.)

Going one more notch up the risk scale, you might even look at some international equity funds. Chalasani figures that there’s a good chance European rates will head lower soon, which could boost stock prices even more than bonds. He recommends putting up to 20% of your equity and fixed-income holdings in foreign funds.

European Yields Representative bond market yields for Britain, France, Germany and the United States for securities maturing in three months, two years and 7 to 10 years.

Country Three months Two years 7 to 10 years Britain 10.4% 9.6% 9.4% France 10.0% 9.1% 8.7% Germany 9.6% 8.7% 8.0% United States 3.8% 5.3% 7.5%

Source: Julius Baer Securities, Los Angeles.