Alluring Foreign Bond Funds Can Be Risky Business
Imagine two cars on opposite ends of a roller coaster, and you’ll get the picture on the sudden divergence between U.S. interest rates and rates in most other countries.
U.S. rates are climbing as investors focus on our economy’s strength. But in Europe, Japan and Latin America, rates remain on a downward slope because economic weakness still is the rule abroad.
On Thursday, we saw new supporting evidence for both trends. Yields on 30-year U.S. Treasury bonds jumped to 6.54%--the highest since August--as investors anticipated inflation rising as the U.S. economy revs up.
Meanwhile, Germany’s central bank cut its short-term discount rate to 5.25% from 5.75%. It was another in a string of cuts aimed at priming the German economy for recovery.
For the millions of Americans who own bonds or bond mutual funds, the polar difference between the interest rate outlook here and the outlook abroad is no minor issue: The simple fact is, rising rates here are eating away at U.S. bonds’ principal values, while foreign bonds are appreciating as market rates slide elsewhere in the world.
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So, is it time to trade your U.S. Treasury or corporate bond fund for a foreign fund? On the surface, at least, that looks like a smart move.
For one thing, long-term bond yields abroad are generally higher or just slightly lower than U.S. yields, which means you may be able to grab a higher current yield than what you’re earning in a U.S. fund (depending on when you bought your U.S. fund).
Second, the likelihood of foreign rates declining further is strong, because there’s no sign of economic recovery in Europe or Japan. “The Europeans figure they’re 18 months behind us” in their economy, said Carl Ericson, manager of the Colonial Strategic Income mixed-bond fund in Boston. Eighteen months ago, of course, the United States thought it was still mired in recession, and interest rates were ratcheting ever lower.
Even in 1993, though U.S. interest rates were still falling for much of the year, foreign rates fell faster. The result: The average foreign bond fund produced a total return (yield plus share-price appreciation) of 17% last year, according to fund tracker Lipper Analytical Services in New York. In contrast, the average U.S. government bond fund’s total return was 9.3% for the year.
Unfortunately, the numbers make foreign bonds look like a layup. They aren’t. The risk in buying foreign bonds today is substantial, experts warn.
Start with currency risk. If our economy continues to expand while Europe flounders, a natural side effect should be a stronger dollar. When the dollar rises, it automatically devalues foreign securities held by Americans--which means you can lose money, on paper, even if foreign interest rates fall and your foreign bonds appreciate in their home country.
A bond fund can attempt to hedge against currency fluctuations using futures and options, and many do. But hedging costs money, and it doesn’t always work as advertised.
For a reminder of the pitfalls in foreign currency fluctuations, think back to the trauma to Europe’s monetary system in 1992, when European nations suffered from a mass devaluation of their currencies. The result was havoc in many U.S.-based foreign bond funds, hedged and unhedged. That year, the average world bond fund’s total return was a paltry 2.82%, even though nominal yields on the funds were over 8%.
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Perhaps the greater risk today in foreign bonds is political, said Robert Di Clemente, economist at Salomon Bros. in New York. Japan is obviously in a political uproar over the trade row with America. In Europe, elections loom in Italy (March), Germany (October) and other countries.
With high unemployment and social strife across Europe, Di Clemente said politicians could be tempted to choose re-inflation (i.e., heavy government spending) as a way out. If that happens, interest rates could reverse in a hurry.
Finally, before you dump your U.S. bond fund because interest rates are rising here, remember that the rise has been going on since last fall. Di Clemente and many other pros believe that long-term U.S. yields are closer to a near-term top than a bottom. This may be the wrong time to sell.
Still, if you can accept the risks in foreign bonds, they may make sense for a portion (say, 20% to 25%) of your bond portfolio. If you don’t want to buy a foreign fund directly (most fund companies offer them), you can get foreign diversification another way: Choose a “flexible” or “mixed” bond fund that can invest in any type of bond. Most of them own at least some foreign issues.
Rates Around the World
How short- and long-term interest ratescompare among major nations:
Government security yields: Country 3-month 10-year Italy 8.50% 8.63% Britain 5.19 6.53 Australia 4.38 6.50 United States 3.35 5.99 France 6.30 5.96 Germany 6.00 5.89 Japan 2.20 3.50
Source: Salomon Bros.
