Why Foreign Funds May Be ‘Keepers’
U.S. investors discovered the hard way this week that anything high-yielding is by definition high risk.
Foreign bond and foreign money market mutual funds, which in recent years have made it easy for Americans to cash in on the double-digit interest rates in Europe and elsewhere overseas, have mostly been slammed by Europe’s currency and interest rate chaos.
The funds, which now hold $30 billion in investors’ assets, have lost as much as 6% of their value since the crisis began nearly two weeks ago. Year-to-date returns on many of the funds now are in or near negative territory.
But before you think about bailing out of a foreign income fund, stop and ask yourself why you bought in the first place. Many investors who panicked and sold out of junk bond funds during their crisis in 1990 regretted that decision in 1991, when junk funds rebounded.
Foreign income funds’ problems this week are twofold:
* First, the dollar has surged versus other currencies. The value of any foreign security (stock, bond or money market) automatically drops when devalued foreign currencies are translated into dollars.
* Second, Italy, Sweden, Britain, Canada and other nations have raised interest rates in an attempt to defend their currencies. Higher rates immediately cheapen the value of older, lower-yielding foreign bonds and money market securities in fund portfolios.
That double-whammy is the worst-case scenario for a foreign income fund. Generally, rising interest rates abroad would mean a weaker dollar, which would help cancel out the impact of the rate rise on fund shares.
But Europe’s crisis blew up so suddenly that many currency traders have sought safe haven in the dollar, despite the lure of higher rates abroad.
Foreign income funds have been caught in the cross-fire. The Van Eck World Income bond fund, for example, has 38% of its $280-million portfolio in Swedish and Spanish bonds. Sweden has been forced to raise interest rates dramatically this week, while Spain was forced to devalue its currency 5%.
The result: Van Eck’s total return (interest plus principal change) year-to-date had shrunk from 7.2% as of Aug. 31 to about 1% by Thursday. So investors have given up 6.2 percentage points of their 1992 return in two weeks.
Other foreign income funds have fared better. Pasadena-based Huntington Global Fund, a foreign money market fund, has lost 2 points off its 1992 return since the crisis began. Its return year-to-date is 5.1%, still well above the 3% returns on U.S. money market funds.
Even if your fund has come through unscathed, it’s worth taking a closer look at what the fund owns and how it may fare as the smoke clears in Europe. Some points to focus on:
* If you own a foreign money market fund: Because short-term interest rates in Europe are actually higher than long-term rates, many Americans have been lured to foreign money market funds. But unlike U.S. money market funds--whose share values remain constant--foreign money funds’ values can drop significantly when the foreign securities they own are devalued, as happened this week.
In fact, many investors may be shocked to discover that foreign short-term funds have performed worse than foreign long-term funds this year, despite the short funds’ higher yields.
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What happened? Many short-term funds try to hedge against currency fluctuations using futures, options and other strategies. But investors have to realize that a fund manager can hedge wrong as often as right. And many short-term fund managers were simply caught by surprise this week as European nations abandoned long-held exchange rate standards. That bomb blew plenty of hedging strategies out of the water.
“This is another cruel lesson that these are not ‘cash’ surrogates,” says Don Phillips of mutual-fund tracking firm Morningstar Inc. in Chicago. The advertised yields on foreign money market funds may be 7% or more, Phillips notes, but that yield comes at a price--the risk of currency losses. If you can’t take that risk, you belong back in a U.S. money market fund, he says.
* If you own a foreign bond fund: Because these funds own longer-term securities and thus take a longer-term view of foreign interest rate and currency trends, many don’t hedge their positions against currency fluctuations. An unhedged fund is completely at the mercy of the market.
By now, given two weeks of turmoil, many bond fund managers have restructured their portfolios against further volatility (read: losses) in some of the most troubled European currencies.
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For example, Klaus Buescher, manager of the Van Eck fund, has abandoned Italian bonds since the crisis began. If the French on Sunday vote against the Maastricht treaty on European unity, Buescher figures that weak currencies such as the Italian lira could suffer further, as investors flock anew to strong European currencies such as the German mark.
But longer term, Buescher believes that the high yields on bonds of countries such as Sweden and Spain will more than compensate for the near-term decline in their currencies’ values.
Buescher also expects the dollar to begin sliding again before year’s end, as Europe’s crisis abates and safe-haven seekers look for new opportunities.
The key for foreign bond fund owners is this: Ask yourself why you own the fund to begin with. Because of the currency risk involved, these funds aren’t meant to hold the bulk of your savings or investment.
They should account for perhaps 10% to 20% of your income portfolio, giving you a higher return than U.S. bonds (at higher risk), while also providing a way to profit should the dollar’s value continue to slide over time.
Dollar Becomes A Hot Ticket The currency crisis in Europe has sent the dollar’s value soaring, as many currency traders and investors have sought out U.S. investments as safe haven. But while the gain gives U.S. travelers abroad more purchasing power, it raises the price of U.S. goods abroad--bad for business. Foreign currency per dollar Britain (pound) Sept. 17: 0.559 Germany (mark) Sept. 17: 1.479 France (franc) Sept. 17: 5.065 Italy (lira) Sept. 17: 1,239.3
Global Bond Fund Crunch
How some global income mutual funds had fared through Sept. 10, and their performance in the week ended Thursday, as Europe’s currency markets turned chaotic. Figures are total returns (interest return plus or minus net change in principal).
Total percentage return:
Fund To 9/10 This week Alliance World Income +1.8% -1.6% Blanchard Short Global +4.6% -0.5% Dean Witter World Inc. +7.0% -2.6% Eaton Vance Short Glo. +2.3% -2.2% GT Global Govt. Inc. +4.3% -3.4% Merrill Short-Term Glo. B -1.4% -0.6% PaineWeb. Global Inc. B +4.3% -2.1% Price Intl. Bond +7.6% -4.0% Scudder Intl. Bond +7.9% -0.2% Scudder Short-Term Glo. +3.9% +1.4%
Source: Lipper Analytical Services Inc.
