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Help Your Clients Get More out of Their Bond Portfolios

This screen zeros in on globe-trotting fixed-income funds that could be welcome supporting players in a portfolio.

Karin Anderson, 08/04/2008

Regional diversification is just as important among fixed-income funds as it is to the equity funds in a portfolio. By holding fixed-income instruments from around the globe, the portfolio could benefit from foreign currency appreciation, higher yields (particularly from fast-growing emerging markets), and less direct exposure to U.S. interest rates.

Of course, there are trade-offs. Currencies do depreciate. Non-U.S. interest rates fluctuate, too, sometimes adversely affecting international bonds. And emerging-markets bond funds have been quite volatile over time, reflecting the risk associated with some markets' lower credit standings.

Over the long term, however, a more balanced portfolio makes sense in a world that is becoming increasingly global. It gives investors exposure to some interesting (and profitable) opportunities while at times smoothing out returns overall thanks to varying economic and interest-rate cycles.

Take emerging markets, for example. Although emerging-markets-bond funds sport impressive performance records and could thus be due for a breather--and when they fall, they tend to fall hard--many global-bond portfolio managers argue that emerging markets are becoming more-attractive places to invest for the long haul. Generally speaking, many of these developing countries are less reliant than they were on external capital flows to finance growth, which is a result of stronger economic and political institutions, as well as lower debt and inflation. As a result, some countries' sovereign debt boasts investment-grade status. Most recently, Standard & Poor's upgraded Brazil in April. Meanwhile, some emerging markets continue to grow at a clip much faster than the United States and other developed markets.

The best options for global fixed-income exposure are our handful of Analyst Picks, but Morningstar Principia and Morningstar Advisor Workstation are great tools for casting a wider net for world-bond, emerging-markets-bond, and multisector-bond funds. We included multisector-bond funds because many of them, particularly our favorites, invest a meaningful portion of assets in international bonds. We performed this screen in Advisor Workstation, but it can also be done in Principia.

First, we limited the screen to reasonably priced funds (those that levy 1.25% annually or less) that are still open to new investment

and require $10,000 or less as an initial investment. We also zeroed in on funds covered by Morningstar analysts.

Special Criteria = Distinct Portfolios Only
And (Morningstar Category = Emerging Mkts Bond
Or Morningstar Category = World Bond
Or Morningstar Category = Multisector Bond)
And Purchase Constraints not = Closed-New Investment
And Audited Expense Rati < = 1.25
And Analysis not= NA

And while we normally screen for solid 10-year performance records, the very limited number of such funds that have been around that long caused us to adjust our screen: We required a top-third finish versus the category average for the past five years and made sure that the current manager was responsible for that record.

And Manager Tenure (Longest) >= 5
And % Rank Cat 5 Yr<= 33

Before revealing our results, keep in mind that as emerging-markets bonds have rallied recently, many of these funds had a big tail wind. Like stocks, bonds move in cycles as economics, valuations, and investors' appetites for risk change, so we urge investors to maintain a long-term investment horizon and keep their expectations in check, particularly over the short term.

As of May 20, our screen pulled a mix of 13 world-bond, emerging-markets-bond, and multisector-bond funds covered by Morningstar analysts. Here are four funds that we especially like.

Templeton Global Bond TPINX
Among the world-bond funds, Morningstar analysts have long been fans of this one. While the dollar has sagged and interest rates have declined, the fund's enviable five-year record is steady. For the trailing year ending May 23, the fund has delivered a peer-beating 12% return. Manager Michael Hasenstab leads the way here, and he and his team generally look for high-quality foreign-government debt. Hasenstab has molded a distinctive portfolio compared with the fund's benchmark, the Citigroup World Government Bond Index, in part because of his willingness to scoop up emerging-markets bonds that he finds undervalued. While more volatile than the typical peer, the fund has delivered the goods during Hasenstab's seven-plus-year tenure.

American Funds Capital World Bond CWBFX
This is another good choice from the world-bond category. Like most funds at this shop, several managers and a team of analysts each run a portion of the fund's assets. The management team is primarily on the lookout for investment-grade debt (the portfolio sports an average credit quality of AA); toward the end of 2007, however, the fund held roughly 25% of assets in local currency-denominated emerging-markets bonds. This allocation, in addition to a roughly 12% stake in junk bonds, has caused the fund to stumble a bit in recent months as nervousness in the markets have caused investors to flee to the highest-quality issues.PAGEBREAK

That said, we're confident in this team's experience and approach; with many managers funneling their best ideas into the fund, the offering has broad country, issuer and issue diversification. This, along with a reasonable price tag, has added up to an enviable long-term record.

DWS Emerging Markets Fixed Income SCEMX
On the emerging-markets bond front, this fund is an interesting choice for bold investors.

Managers Brett Diment, Edwin Gutierrez, and Nima Tayebi run the show. A large allocation to Turkey--which has a large current account deficit--slowed returns in late 2007 and into 2008. Likewise, the fund was also hurt by its investments in politically riskier areas such as Venezuela and Argentina. But the managers also invest in issues from Brazil and Mexico. These countries tend to be favored by other managers in this category because of the stability that has come from soaring energy prices and the relative strength of those countries' economic and political institutions. In the end, we think the managers' bolder approach may help diversify a portfolio.

Franklin Strategic Income FRSTX
This is a multisector-bond offering run by Chris Molumphy, who heads up the firm's bond research group, and by Eric Takaha from the high-yield research team. While multisector- bond funds are defined by their managers' ability to invest anywhere in the fixed- income universe, this fund has been a bit bolder than most.

For one, managers have kept a rather hefty stake in high-yield issues, though they did begin to pare that back in early 2007 because they didn't think they were adequately compensated for those risks. The managers have also held more emerging-markets debt than most peers have, even venturing into low-trafficked areas such as Iraqi sovereign debt. They generally keep most of their foreign allocation devoted to investment-grade debt, however. In the end, we think that the analyst bench at Franklin provides these managers ample resources to take on these extra risks. We also like the fund because its low expense ratio has given it a hand in achieving peer-beating returns over long time periods.

Karin Anderson is a fund analyst with Morningstar.

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