THE DOLLAR UNDER PRESSURE : There’s More to Foreign Bonds Than Big Yields
Investors who want to play the falling dollar are finding that foreign bonds are the way to go: Not only do the bonds appreciate in value as the dollar sinks, but the yields they pay are far above U.S. interest rates.
Yet with the dollar already at all-time lows against the German mark, some experts are warning investors against making oversized bets now on foreign bonds, and in particular European bonds. Those high yields may look tantalizing, but they could be meaningless if the dollar suddenly rockets.
Tuesday, the dollar stabilized after falling sharply for much of the last week. It closed in New York at 1.402 marks, virtually unchanged from Monday.
Since spring the dollar has dropped from 1.65 marks, a purchasing-power loss of 15%.
While some analysts have suggested the bottom for the dollar may be 1.30 to 1.35 marks, that’s still a small move compared to what’s already occurred. “One would have to think we’re much closer to the end than the beginning of this,” says Robert Sinche, global fixed-income chief for Alliance Capital Management in New York.
His investment company and many others have made it easy for the average American to invest in foreign currencies via foreign bonds. There are now more than 100 mutual funds that specialize in such bonds. Assets in those funds now top $30 billion, versus $17 billion two years ago.
Indeed, the dollar is so weak partly because so many Americans have dumped their U.S. investments for high-yielding foreign bonds--in the process trading dollars for foreign currencies.
So far this year, investors in foreign bond funds have been collecting annualized yields in the 6% to 9% range. On top of that, each drop in the dollar is gravy if you own foreign bonds: As foreign currencies buy more dollars, foreign bonds also become worth more in dollars.
In the week ended last Thursday, for example, the Boston-based Scudder International Bond Fund appreciated 0.5% as the dollar slumped. For the year to date, the fund’s total return (interest plus capital gain) is 6.92%, while funds that own U.S. Treasury bonds have typically earned 5% to 6%.
But foreign currency fluctuations can cut both ways. If the dollar begins to appreciate, the capital-gain effect for U.S. investors in foreign bonds would quickly become a capital-loss effect.
Consider the Scudder fund’s experience in the first quarter of this year, when the dollar was rising. The fund lost 3.83% for the quarter, as a slide in foreign bond values more than offset the interest they earned.
Is the dollar ready to snap back? Most money pros can’t see it anytime soon, given the weak U.S. economy. But even if the dollar should strengthen, foreign bonds may still make sense--if, as expected, high foreign interest rates finally begin dropping as foreign economies slow.
Declining interest rates would make older foreign bonds more valuable, partially or entirely offsetting the potential capital loss on foreign bonds caused by a strengthening dollar. If the net result is a wash, your investment’s value would hold steady, while you’d still be earning higher yields (even on the way down) than what U.S. bonds pay.
Of course, that’s the best-case scenario. If U.S. interest rates rise while foreign rates drop and the dollar gains, foreign bonds could wind up being a disastrous investment in the short-term.
Depending on the type of foreign bond fund you buy, the fund itself may hedge its bets on the dollar’s movements. For example, a fund manager might use currency futures to minimize the damage to the fund should the dollar rise. Typically, shorter-term foreign bond funds hedge a great deal; longer-term funds may not.
Before buying any foreign bond fund, ask about its hedging policy. Hedging isn’t a panacea. The manager may hedge incorrectly, causing the portfolio more harm than good. At the very least, hedging costs the fund money, and thus reduces your interest yield. There is no free lunch.
That’s why you don’t want to sink your entire life savings into a foreign bond fund now, says Gary Brinson, whose Brinson Partners in Chicago manages $23 billion. With political and economic uncertainty in the United States, and Europe at the mercy of high German interest rates, it’s impossible to know which way global rates and currency relationships are headed in the short run.
But if you have a long-term perspective, and you now own only Treasury bonds or other U.S. bonds, Brinson believes that it’s still smart to consider moving 10% to 20% of that bond money into foreign bonds.
“A properly diversified bond portfolio should be done on a global basis today,” Brinson says. While many Americans might assume that diversifying into foreign investments makes their portfolios more risky, Brinson says the opposite is in fact true: “The evidence is that you reduce your risk.”
The accompanying chart might explain why. Since 1986, annual returns on U.S. government bond funds have tended to seesaw with returns on foreign bond funds: In many years, one category has dramatically outperformed the other.
Trying to guess in advance which would have been the better category would probably have been futile. By owning both, an investor could have earned a decent blended rate of return, while avoiding the risk of having placed all one’s chips on the worst bond category.
Why the Dollar has Sunk
Investors searching for high yields worldwide can find the best returns in Europe--which is why money is flowing out of dollars and into European currencies.
Yields on five-year government bonds
Spain: 13.38%
Italy: 13.20%
Britain: 9.73%
France: 9.69%
Germany: 8.31%
U.S.: 5.74%
Source: Bloomberg Financial
Foreign Bond Funds vs. U.S. Bond Funds
Mutual funds that own foreign bonds offer a way to offset the risk in funds that own only U.S. government bonds: In three of the last six years, foreign funds provided high returns even as U.S. funds waned. Here are average total returns (yield plus or minus principal change) for the two categories:
Average total investment return: Foreign U.S. government Year bond funds bond funds 1986 +30.17% +11.98% 1987 +20.69% +0.64% 1988 +5.21% +6.68% 1989 +6.94% +12.33% 1990 +13.05% +8.10% 1991 +14.21% +14.60% 1992* +3.89% +3.92%
* through July 31, before dollar’s latest slide
Source: Lipper Analytical Services
