GLOBAL INVESTOR: Holiday in the sun--International bonds still hold attraction for itinerant investors

By Barbara Kollmeyer, <a href=cbs.marketwatch.com>CBS MarketWatch Last Update: 12:02 AM ET May 12, 2003

LOS ANGELES (CBS.MW) - For most U.S. investors, international bonds can be too complicated to bother with, especially when measured against the comfort of good old Treasury bonds. But international bonds could be just the diversifier your portfolio has been looking for, even if you have to dust off that world atlas.

Investors have been dipping deeper into the international bond market waters in search of higher yields. Emerging market bond funds took in $1.81 billion year-to-date, nearly three times all of last year's inflows, according to EmergingPortfolio.com, which tracks foreign bond investment. And international bond funds have taken in $1.69 billion year to date, well up from the $9.47 million of net inflows last year.

Fueling this attention is a growing perception that the three-year U.S. T-bond rally is losing steam because of an increasingly weaker dollar and the possibility of rising U.S. interest rates, both downward drivers for bond prices.

"We don't think Treasury yields have lower to go," said David Rolley, senior portfolio manager at bond mutual-fund powerhouse Loomis Sayles. "If you lend money to the government today, they'll pay you 3.72 percent. That's not a lot."

Indeed, especially when compared to returns such as these: the MSCI Emerging Market Sovereign Index has gained 15 percent year-to-date, on the heels of a 45.5 percent gain in 2002, while J.P Morgan's Emerging Market Bond Index Plus is up 24.9 percent year-to-date.

Tasty returns don't come without risk, of course. Outside of most developed markets, investors need to remember that they're loaning their money to a country or company and a default risk, while remote in the case of a sovereign borrower, is still possible.

But looking beyond T-bonds can bring rewards. "Go into it for diversification," said Andrew Clark, senior research analyst at mutual fund research firm Lipper. "To hold some portion of your bond investment overseas makes a whole lot of sense."

Exploring emerging markets

International bond funds tend to hold either government or corporate bonds or both, and usually include a variety of countries. Emerging market debt has captured the spotlight lately, though the landscape is constantly changing and investors need pay close attention to individual countries, rather than regions or indexes.

"With emerging market debt, you can get nasty surprises. If you want to play that market great, you can get nice returns. Just make sure you're reviewing your holdings once a quarter to ensure you're comfortable with your exposure," Clark said.

Mohamed El-Erian, portfolio manager of the $1 billion Pimco Emerging Market Bond Fund (PEBIX: news, chart, profile), says Brazil, along with Peru, Columbia and Ecuador are "return engines," with more volatility, but better rewards. "The driver is good fundamentals," he added.

He also likes investment grade countries that are relatively stable, which promise yields of 6 to 8 percent. His picks in this category include Mexico, Panama, Poland, Hungary, Malaysia and Russia, the latter a favorite for many fund managers.

"Russia's credit has benefited from high energy prices, reflected in record level of international reserves -- they've benefited from the impact of the crisis of 1998," El-Erian said. "They have strong fiscal accounts and their credit worthiness has been enhanced significantly in the last few years."

One factor that has drawn in more investors to emerging market bonds is a long-term, favorable re-pricing of the emerging market asset class -- helped by improved fundamentals and credit quality of countries, said El Erian. "Whether you look at the amount of upgrades, downgrades or average quality or investment grade credits, now over 40 percent of credits are investment grades," he explained.

Ultimately, though, those playing the emerging market debt game should view it on a three-year cycle, said El-Erian, whose fund concentrates mostly on sovereign debt rather than corporate. And some countries just don't compensate enough for the risk. He cites patients in his "intensive care unit" such as Venezuela, Turkey and the Philippines, where even the short-term fiscal outlook is questionable.

A window on the developed world

The three-year U.S. bond rally has benefited Europe and Great Britain as well. Of course, flattering returns for debt in some funds have stemmed from the euro's appreciation against the U.S. dollar rather than high yields.

"People need to keep in mind that these funds tend not to be fully hedged from a currency standpoint," said Lipper's Clark. "As long as the dollar continues to weaken, they'll get a nice kick." But if the euro flattens out or reverses course, international bond fund investors could be hurt.

European bonds also have seen benefits from the view that interest rates on the Continent can go lower, while U.S. rates are believed to be bottoming.

Loomis Sayles' Rolley says non-dollar denominated debt could outperform over the next 12 months, particularly the euro. "When the dollar goes down, something has to go up. The euro is the most likely candidate. There's not much inflation in the U.S. and even less in Europe.

Rolley also likes Australia, New Zealand and Canadian bond markets, which all have higher yields than the U.S. and appreciating currencies. His group does dip into corporate bonds, but he says investors need to build a broad portfolio of companies rather than focus on a few.

Get the mix right

Just how much to devote? Peter Needham, a financial planner with American Economic Planning, prefers Europe to the more speculative emerging markets. He uses funds such as Julius Baer Global Income (BJBGX: news, chart, profile), which has 20 percent of assets in foreign bonds. He also likes PIMCO Foreign Bond (PFRAX: news, chart, profile), which has some exposure to Mexico and Canada.

Bridget Hughes, senior analyst at Morningstar Inc., points to another couple of top performers -- American Century International Bond (BEGBX: news, chart, profile) and Federated International (FTIIX: news, chart, profile).T. Rowe Price International Bond (RPIBX: news, chart, profile) is also inexpensive with a good manager and track record, she said.

Adds Rolley, the Loomis Sayles manager, "Global bonds as an asset class has been almost a perfect diversifier for a portfolio that includes equities." But watch this market carefully. If a worldwide bull market in stocks ever returns, international bond investors could be left without a ticket home.