The Wall Street Journal-20080213-Investors Flock To Foreign Bonds- Amid Dollar Weakness- Funds Offer Exposure to Other Currencies With Less Risk Than Stocks- Emerging vs- Developed Markets

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Investors Flock To Foreign Bonds; Amid Dollar Weakness, Funds Offer Exposure to Other Currencies With Less Risk Than Stocks; Emerging vs. Developed Markets

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After embracing foreign-stock funds in recent years, investors are now starting to pay increasing attention to foreign-bond funds.

Inflows into foreign-bond funds doubled last year, with investors pouring $19 billion into them. Total assets managed by these funds nearly doubled in the past two years, reaching $84 billion, according to research firm Financial Research Corp.

Foreign bonds offer many of the same benefits as international stocks, such as foreign-currency exposure -- a possible opportunity to profit if the U.S. dollar weakens further -- and a chance to tap into economies that are growing faster than that of the U.S.

At the same time, foreign bonds are often considered safer than foreign stocks, though risks vary. There are many different types of government bonds -- ranging from ultrasafe bonds in Germany, paying yields as low as 4%, to riskier bonds in emerging markets such as Brazil, paying yields of 13% or more. Corporate bonds often pay more but are even riskier.

Louis Stanasolovich, a Pittsburgh-based financial planner, recently doubled his clients' exposure to foreign-bond funds to about 5% of his recommended "low volatility" portfolio. He currently uses funds that buy short-term bonds, such as Pimco Developing Local Markets, as a way to get higher yields, as well as to benefit from potential currency gains.

Fund companies are fanning the fire by offering more products: Nearly a fourth of the approximately 100 foreign-bond funds were launched just in the past two years. Already this year, for example, Franklin Templeton Investments and Loomis Sayles & Co. have each launched such a fund -- on top of their existing international-bond funds -- and in the next several months, more exchange-traded international-bond funds are expected to come to market. ETFs are baskets of securities that resemble index mutual funds but trade like stocks.

Buyers of foreign bonds are betting that the dollar will continue to weaken against other currencies, which makes the underlying bonds, bought in local currencies, worth more in dollar terms. That's exactly what happened last year as the dollar declined against many major currencies. Funds that invest primarily in developed-country bonds on average returned 10% for the one year and 6.5% for the five years ended Feb. 11, according to Morningstar Inc. A major portion of these gains came from currency returns. So far this year, the dollar is up 0.1% against the euro but is down 3.7% versus the yen.

But currency movements are notoriously hard to predict, and some money managers think that the decline of the U.S. dollar -- particularly against the euro -- might be close to over. The other major risk is that some foreign countries, especially emerging ones, may be more likely to default on their bonds.

Besides currency movements, there's another reason why foreign bonds could get a pop this year. The Federal Reserve has been slashing U.S. interest rates in recent months, but central-bank interest rates remain high in foreign markets such as Mexico, where the rate is 7.5%. With the global economy slowing, managers expect other foreign central banks to lower rates, in an effort to boost local economies. Because of the inverse relationship of interest rates and bond prices, a drop in foreign rates would further boost foreign bond prices.

It's possible for individual investors to buy sovereign bonds directly from certain developed countries, but the process can get complicated, leaving funds as a good choice. Still, investors need to pay attention to the risk a fund is taking. Funds with "international" or "global" in their name typically invest the bulk of their money in high-quality government-issued bonds but have leeway to buy riskier corporate bonds, as well as below-investment-grade and emerging-market bonds.

Funds with terms such as "developing markets" or "emerging markets" in their names primarily buy developing-country bonds. These bonds carry a higher risk of not being able to pay back their debt, as happened in 2002, when Argentina didn't pay back creditors.

Many of the emerging-market funds, moreover, buy bonds that are issued in U.S. dollars and therefore miss out on currency gains. The average emerging-markets bond fund is up 5% in the past year and 13% annually over the past five years, according to Morningstar.

Not all foreign-bond funds provide currency exposure. Some, like Pimco Global Bond (U.S. Dollar-Hedged), as the name suggests, hedge against currency risk. Others, such as Templeton Global Bond, give the manager flexibility to make hedging decisions. Some funds even hold bonds in one country but use complex hedging so that they are actually exposed to the currency of a different country.

For instance, at Templeton Global Bond, manager Michael Hasenstab invests in Mexican bonds because he thinks these will benefit from interest-rate declines this year, but he doesn't think that the Mexican peso will do well against the U.S. dollar. So, through some complex investments, he has eliminated all exposure to the peso and has instead bought the Indian rupee, which he expects will appreciate further this year.

At Pimco, fund managers think Asian currencies will do well this year, particularly those of countries closely linked to trade in China, such as Malaysia, Indonesia and South Korea. Some of Pimco's foreign-bond funds actually own U.S. mortgage-backed securities issued by Fannie Mae because Pimco managers think these securities are attractively priced. But the funds are hedged so that they'll still perform as if they owned assets denominated in foreign currencies.

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Going Abroad

Foreign bond funds are gaining traction with investors.

Here's what you need to know:

Such funds can provide exposure to foreign currencies and higher yields.

Foreign bonds are generally considered safer than foreign stocks, but

those from emerging markets are riskier than those from developed

countries.

Some managers expect foreign countries to cut interest rates, which would

boost bond prices.