A safer way to invest in foreign bonds

  @Money August 28, 2012: 2:33 PM ET
inv 09 tune foreign income

Tune your strategy: Don't let the European debt crisis or China's slowdown strike a discordant note in your portfolio.

(MONEY Magazine)

Income-starved investors looking to amp up their portfolios have been turning to foreign bonds -- for obvious reasons.

The 4.2% payout on the average foreign fixed-income fund dwarfs the yield on U.S. bonds by about 1½ percentage points. Lately, though, that extra income has come at a steep price.

As interest rates and currencies have swung violently amid the global slowdown and European credit crisis -- yields on 10-year Italian debt have gone from 7.3% to 4.8% and back up to 5.8% in the past nine months -- foreign bond funds have been rocked.

SPDR Barclays Capital International Treasury Bond ETF (BWX), which owns mostly foreign government debt, is down 4% since last September, more than wiping out its yield from the prior year.

Emerging-market bond funds have been even more skittish, losing 4.6% just in May on worries that China's slowdown will crimp growth in the developing world.

Related: Chinese manufacturing slumps to 9-month low

Given that bonds are supposed to add ballast -- not instability -- to your portfolio, it raises the question whether foreign debt is worth the trouble. Yes -- as long as you adhere to certain guidelines:

Cap your foreign exposure. Tony Rodriguez, co-head of fixed income at Nuveen Investments, says investors ultimately need the global diversification and yields that foreign securities offer. But he recommends limiting this stake to around 15% of your bond portfolio.

Since 1985, this conservative allocation has captured roughly 96% of the returns of a more aggressive 40% foreign/60% domestic bond strategy, while being 20% less rocky, according to Morningstar.

Take a tour of London's financial crisis

Hedge your currency bets. It's not just the added yield that's given foreign bonds a boost. So, too, has the long-term decline of the U.S. dollar, which pads the gains of Americans investing abroad.

Between 1972 and 2011, a basket of bonds from 19 foreign markets returned an annualized 4.6%, according to a study by Credit Suisse. However, if those investments had been hedged -- a process where fund managers sell the same amount of foreign currencies they purchase to buy foreign bonds -- that same basket would have gained 3.1% annually.

What's the point of hedging, then? Because doing so produced a portfolio that bounced up and down 60% less than an unhedged approach over the past 40 years. Plus, in case you haven't noticed, the dollar has been strengthening over the past year, largely because global investors view dollar-denominated assets as safe havens.

Don't think this trend will hold? Or maybe mitigating risk isn't your sole goal? Then stick with unhedged developed-market funds. But consider hedging funds that own emerging-market debt, since there's greater volatility in those markets and currencies, says Kathy Jones, fixed-income strategist at the Schwab Center for Financial Research.

You can do so through a fund like Fidelity New Markets Income (FNMIX). John Carlson, Morningstar's bond manager of the year in 2011, limits this fund's foreign currency exposure to no more than 20%.

Think active management. Most bond indexes base their country exposure on the total value of global debt. That means index funds will expose you mostly to the biggest countries and debtors.

The top two allocations for the S&P/Citigroup International Treasury Bond Index, for instance, are Japan and Germany, whose 10-year bonds are yielding 0.8% and 1.3% -- hardly catnip for income investors. Also in its top five are bonds from debt-plagued Italy.

Related: Eurozone nearing another recession

"The long-term fundamentals in smaller economies are where we see value," says Peter Wilson, co-manager of the Wells Fargo Advantage International Bond Fund. Among the biggest country allocations for his $1.7 billion portfolio are Canada and Australia.

Canada has less debt as a percentage of gross domestic product than the U.S., while Australia's economy is on pace to grow 3.4% this year, vs. just 2% for the U.S. Plus, Australia's 10-year bonds are yielding about 1½ points more than Treasuries -- sweet music for income seekers. To top of page

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