Now Is a Good Time to Get Into Foreign Bonds

American mutual fund investors, most of whom have few if any foreign bond holdings, now have a good opportunity to get into or add to those positions.

Global money managers say the sharp rise in interest rates--a surge precipitated by rising U.S. interest rates as much as anything--have made European bonds attractive.

European yields have risen more than U.S. yields, “a scenario not justified by the economic fundamentals,” says Philip Saunders, London-based portfolio manager of the new Guinness Flight Global Government Bond Fund, whose marketing arm is headquartered in Pasadena.

He cites 10-year German government bonds, whose yields were 5.5% on Jan. 1 but now pay about 7.3%. French government bonds with similar maturities have risen from 5.7% to 7.9%, and comparable British debt has increased from 6.3% to 8.9%. Yields on U.S. Treasury bonds with 10-year maturities have risen less drastically, from about 5.9% at the start of the year to about 7.3%.

Reflecting the increase in yields, the average world bond mutual fund tracked by Morningstar Inc. of Chicago was off about 5.5% for the year to date through July. That’s on pace for the worst showing for the category since 1982, one year after the first international bond fund made its debut.

Investors who want to move into the market can now use efficient and convenient foreign bond mutual funds.

The sharp price declines in Europe this year are partly explained by the five interest rate increases engineered by the Federal Reserve Board since February. The Fed’s actions snapped a multiyear global bull market in bonds.

Another factor that has worried investors is the likelihood of stronger economic growth in Europe this year, which could translate into an inflationary burst.

Contributing to the inflationary scare is the fact that most European governments are running budget deficits. Sweden’s and Italy’s are particularly high, dwarfing even Washington’s in percentage terms, says Jeff Tyler, portfolio manager of the Benham European Government Bond Fund in Mountain View, Calif.

But Saunders notes that Europe also has higher unemployment than the United States and is operating at lower industrial capacity. Those factors would tend to argue against an inflationary spike.

Besides, the higher European interest rates will in themselves tend to act as a brake on economic growth and inflation, notes Larry Teitelbaum, lead portfolio manager of the Scudder International Bond Fund in New York.

The Scudder fund now has 70% of its assets invested in European bonds, up from a normal weighting of 55% to 60%.

“We do feel European bonds are attractive,” Teitelbaum says.

However, investing in European bond markets does involve the considerable risk posed by currency fluctuations or the cost of hedging against them. Any weakening of European currencies against the dollar would eat into the returns American investors earn on international bond funds. Conversely, a weaker greenback would increase returns in dollar terms.

Teitelbaum and Saunders fear that, after the dollar’s long slide against key European currencies, the next move will be up. Consequently, both have hedged their funds against the danger of a stronger dollar.

Tyler, however, is not convinced that the dollar will rise, and he has the Benham fund completely unhedged at the moment.

An interesting perspective on currency risk comes from Derek Sasveld, a consultant at Ibbotson Associates in Chicago, who argues that investors should favor unhedged foreign mutual funds.

Foreign bond investments can actually enhance overall returns and reduce risk when combined with a purely U.S. bond portfolio, Sasveld says. That’s because these investments tend not to move closely in sync with U.S. bonds over time.

“A large portion of the diversification benefit comes from the currency play,” Sasveld says.

Besides, it costs money to hedge a foreign bond portfolio, and this extra outlay will add to a fund’s expense ratio.

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But there is a limit to the diversification benefit a foreign bond fund can add to a portfolio. Sasveld suggests placing no more than 25% to 30% of your overall holdings in international investments. Of that, foreign stock funds should account for roughly 17% to 20%, foreign bond funds the remaining 8% to 10%.

That isn’t a particularly high stake to risk in overseas bond markets, particularly with European yields now much richer than they were at the start of the year.

“European bonds aren’t a screaming buy, but I think they will hold their values better than U.S. bonds,” Tyler says.

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Balanced portfolios--mutual funds that hold both stocks and bonds--are flirting with their worst year since the 1970s. On average, they were down 2.2% from January through July of 1994, Morningstar Inc. reports.

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But investors shouldn’t give up on the balanced approach, says Douglas D. Ramos, co-manager of the Boston-based New England Balanced Fund, which has held up better than most. An unusually bad bond market earlier in the year explains the category’s poor showing, he says.

Ramos, who works in Pasadena, doesn’t think the declines will persist. He sees stable bond prices and flat to higher stock prices by early 1995.

“Long-term, balanced funds should return 8% to 9% a year,” he says. That assumes a typical 60-40 stock-bond split.

Because of their greater diversification, balanced funds offer more upside potential without much additional volatility compared to a pure bond portfolio for investors willing to hold at least three years, Ramos points out.

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Retail securities brokers earned median pay of $90,000 last year, an amount that easily eclipsed the previous record of $78,200 set in 1992, reports the Securities Industry Assn. of New York. It was the fifth consecutive year of higher compensation.

Brokers who cater to institutional clients generated median 1993 earnings of $183,200, also a record and also the fifth consecutive yearly increase. That was up from 1992 pay of $156,000.

Mutual funds have been a growing compensation source for many brokers in recent years, but the SIA report doesn’t disclose their effect on yearly pay.