2 ways to invest overseas for safety

By Tim Middleton

With stock markets writhing in turmoil, investors are looking for safety, and looking to bonds.

Federal Reserve Chairman Ben Bernanke is showing a toughness toward financial speculation that his predecessor never did. Instead of a quick interest rate cut to bail out subprime mortgage lenders, Bernanke is standing firm against inflation by holding rates steady. Since bondholders get paid in tomorrow's money, an anti-inflation central banker is their best friend.

But bond investors are likely to get bigger rewards from foreign debt, because overseas regulators are being equally tough, which means more downward pressure on the U.S. dollar.

"The European Central Bank is continuing to maintain a vigilant stance against easy finance. We think the euro will likely move toward $1.40," says Sudi Mariappa, manager of Pimco Foreign Bond Fund (Unhedged) (PFUIX). Last week one euro was worth $1.337.

Pure portfolios

Mutual funds offer the easiest access to the bonds of other nations and their corporations, but the industry largely lumps them in with domestic debt into what are called world bond funds. The purer play is funds that invest strictly in foreign bonds, and the purest of all is buying funds, like the Pimco portfolio, that don't hedge currencies.

The only other one I've found that I can recommend is T. Rowe Price International Bond (RPIBX). Pimco is strictly a bond shop -- the largest American one -- and its expertise is demonstrated across its entire fund lineup. T. Rowe Price is best known for equity management, but London-based Ian Kelson has established an exceptional record in his six-plus years running the foreign-bond fund.

The case for foreign bonds comes down to this: Global economies are growing, generally without significant inflation. In the United Kingdom and the United States, however, price increases are running ahead of the comfort level of central bankers, although not dangerously so. In each nation, monetary authorities are showing resolve to combat it.

By so doing, they are strengthening the hands of other central bankers, notably in Europe, where combating inflation is the sole central-banking job. (In the United States, the Fed is also charged with responsibility for fostering economic growth.)

The absence of inflationary expectations is demonstrated in the prices of long-term bonds. Central bankers can manipulate short rates, but only the market sets the long end. In the United States, long rates are lower than short ones. Last week a three-month Treasury bill was yielding 4.9%, compared with the 4.625% coupon of the 10-year Treasury.

In Europe, the largest non-U.S. bond market, yield curves are flat; short and long rates are the same. Since long-term bonds have more risk, yields usually curve up. Instead, markets are saying there's more risk in the system now than there will be in the future.

This also means that higher short-term interest rates are not pushing up long rates, as they usually would, but actually are holding them down. In the past year, intermediate-term bonds, those with effective maturities of five or six years, delivered nearly twice their three-year average return in the United States and more than that overseas.

Top foreign bond funds

	Total returns, in %
	YTD	1 year	3 years	5 years
T. Rowe Price International Bond (RPIBX)	1.22	8.51	3.65	10.43
Pimco Foreign Bond (Unhedged) (PFUAX)	1.21	7.56	n/a	n/a
Pimco Foreign Bond (Hedged) (PFOAX)	0.65	3.57	4.17	4.92
iShares Lehman US Aggregate Bond (AGG)	1.52	5.96	3.03	n/a

Notes: as of March 28; n/a -- not applicable; fund not in existence entire period.
AGG represents the U.S. market for comparison.
Sources: MSN Money, Morningstar

This table shows why I favor unhedged exposure to currencies. Pimco's Mariappa manages a twin foreign-bond portfolio that hedges to the U.S. dollar, and it generally lags its unhedged sibling.

Mariappa's fund has benefited from its generally conservative cast, as well as selective bets on individual markets. Recently it has had nearly half its assets in Euroland, much more than a global bond fund. The European Central Bank began raising short rates in 2005 amid burgeoning local economies, increasing them five times last year and another quarter-point in March, to 2.75%.

"The actions of central banks themselves are reinforcing an inflation-fighting credential that you've seen with the Fed," Mariappa says. "This is just a short-term tightening to cause a slowdown. The market is pricing (interest rate) cuts in the U.S. and the U.K., and somewhat in Europe."

Betting on the yen

The Pimco portfolio is also heavily overweighted in Japan, where the yield curve is positive, but on an extraordinarily low base: 0.5% for overnight money and 1.7% for 10-year bonds. Mariappa expects short rates to rise to 1%. But he also expects the yen to appreciate against the dollar, especially as Japan's export-led economy fuels growth in India and China.

The T. Rowe Price fund follows what Morningstar analyst Arijit Dutta calls a "thoughtful, valuation-conscious style." It is bolder than the Pimco portfolio, routinely making sizable forays into emerging market debt; last year's sprightly 7.6% gain was partly due to that theme.

"We're generally constructive on emerging markets from a strategic perspective," says Chris Dillon, a U.S.-based member of Kelson's T. Rowe Price team. China is managing 10% growth without inflation as it pivots from an agricultural to an industrial base.

Building out China also demands vast quantities of industrial commodities, and other developing nations "are disproportionately exposed to the commodities that China will need as it evolves," Dillon says.

At the end of the year Kelson's portfolio represented 52% exposure to the euro, 27% to the yen and 9% to the British pound, with the balance distributed among much smaller positions in places like Mexico, South Korea and Scandinavia.

In my personal portfolio, foreign bonds represent 20% of income assets, up from zero just a few years ago. As with foreign stock funds, I like them for the diversity they bring, and particularly their currency bonus.

At the time of publication, Tim Middleton owned or controlled the following security mentioned in this article: T. Rowe Price International Bond Fund.