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International Isn't Just for Equities

Our take on four globally minded fixed-income mutual funds.

Lawrence Jones, 10/23/2006

Investors have long been aware of both the diversification and performance benefits that come from holding a segment of their portfolios in non-U.S. equity investments, even if the experts can't always agree on the proper proportion for this international stake.

A similar case can be made for the fixed-income side of a portfolio. Holding international bonds can add useful diversification, as foreign bond markets' performance will often not correlate with domestic fixed-income return movements. And if the securities held are denominated in different currencies, international bonds can also provide investors with foreign currency exposure not easily attainable elsewhere.

And given the extraordinary growth of bond markets overseas, investors ignore international fixed-income markets at their risk. Bond giant PIMCO, for instance, has pointed out that while the U.S. has long been the dominant player in the world's fixed-income marketplace: "Bonds issued in the U.S. now account for less than half of the global bond market.... In other words, avoiding non-U.S. bonds is no longer an option because it limits investors to only half of the available universe of bonds."

Moreover, eminent investors as diverse as PIMCO's Bill Gross and Berkshire Hathaway's Warren Buffett (as well as many others) have long believed that the U.S. current account deficits will likely lead to downward pressure on the value of the dollar relative to other currencies. In fact, Gross believes that the situation could lead to the eventual abandonment of the "strong dollar" policy, and he has counseled investors to move part of their portfolio away from U.S. assets and "toward more competitive economies."

The upshot for investors is that there are several good reasons to consider fixed-income markets from a global perspective. With that in mind, we offer four funds that we think can play a role in many investors' portfolios.

Loomis Sayles Global Bond LSGLX
We like this world bond's experienced management and approach. Fund managers Kenneth Buntrock and David Rolley have significant international investment experience. Prior to joining Loomis Sayles in 1997, Buntrock worked at Mellon Bank in various capacities, including as manager of its foreign exchange currency-trading unit. Rolley's background is in macroeconomic analysis, having held positions as an economist at Drexel Burnham Lambert and as chief financial economist at Wharton Econometric Forecasting Associates (now Global Insight) before coming to Loomis in 1994.

Additionally, management is well supported by a seasoned research analyst team. The approach practiced here combines management's macroeconomic outlook, which helps determine the fund's country, currency, and interest-rate positioning, with the value-conscious fundamental research effort for which Loomis Sayles is well known. Depending on their market outlook, Buntrock and Rolley will take varying levels of country, credit, and interest-rate risk.

For example, although homebuilders in the United States are suffering from a slowing housing market in 2006, management saw an opportunity in purchasing bonds issued by Mexican homebuilder Homex HXM, which has a sound balance sheet, and has benefited greatly from the recent expansion of mortgage financing in that country. Additionally, while the Mexican peso has been lagging the dollar of late, the Homex bonds purchased are denominated in U.S. dollars, thus avoiding the peso's slide and preserving the bond's solid return.PAGEBREAK

T. Rowe Price International Bond RPIBX
We've been pleased with management's experience and approach, which, unlike many in the world-bond category, provides foreign-only fixed-income exposure to investors, largely in local foreign currency.

Lead manager Ian Kelson worked as head of fixed income for Morgan Grenfell/Deutsche Asset Management before joining this fund in 2000. He is backed up here by comanagers Chris Rothery, Mike Conelius, and an expanding analyst staff. While Kelson will hold much of the portfolio in the sovereign debt of developed countries, he will venture into emerging-markets debt, such as Brazil, at higher levels than many rivals will. While this can occasionally court country and currency risk, as during the May to June emerging-markets sell-off, management has handled such turbulence well in the past, and we expect it will continue to do so going forward.

The team has also achieved a solid long-term record at T. Rowe Price Emerging Markets Bond PREMX. While the International fund's 2005 performance was a disappointing 8.18% loss, this had to do more with the risks of running an unhedged currency portfolio during a year of dollar strength than with management missteps.

Oppenheimer International Bond OIBAX
This fund's manager, Art Steinmetz, has a great deal of international bond investment experience, both here and at the Oppenheimer Strategic Income OPSIX foreign-bond segment, which he has run since the fund's October 1989 inception.

In addition to management's experience, the fund's more-aggressive approach to international-bond investing may appeal to those who are able to handle its risks. With nearly 45% of the fund's assets in emerging-markets debt, the offering has one of the highest stakes in this riskier sector of the foreign-bond market. That exposure adds to the fund's diversification potential, as it will not move in lockstep with developed-market foreign and U.S. bond markets.

Additionally, the fund will typically keep the majority of its positions unhedged, while selectively hedging, or holding dollar-denominated emerging-markets debt, which Steinmetz has shown a talent for over time, particularly in his use of derivatives. For example, in 2004, when the dollar showed substantial weakness, the fund's local currency issues performed strongly, while in 2005 when the dollar displayed unexpected strength, the fund's dollar-denominated emerging-markets bonds helped returns.

Julius Baer Total Return Bond BJBGX
This fund is unusual in this grouping for not being in the world-bond category but rather an intermediate-term bond fund that takes significant positions in foreign bonds.

Manager experience and the fund's approach are also the factors that make it distinctive. Veteran manager Richard Pell, who was named Morningstar International Stock Manager of the Year in 2002 for his work on Julius Baer International Equity BJBIX, where he serves as comanager, handles the broad macroeconomic oversight at the fund. Donald Quigley, who has focused more on the daily management here over the past five years, has also worked at Chase Asset Management and Met Life Insurance Co. as a portfolio manager and fixed-income trader, respectively. The duo is supported by a team of several experienced analysts.

The approach here involves focusing mainly on the investment-grade U.S. domestic-bond market, where management can range widely across government, agency, corporate, mortgage-, and asset-backed securities, but management will often stash as much as 30% of fund assets in foreign sovereign debt, both on a hedged and unhedged basis. This foreign segment sets the fund apart from the majority of its category peers and provides investors a way to gain international fixed-income exposure, including currency exposure, without moving fully into an international bond fund. Some of management's international positions can seem a bit esoteric, such as a position it held in 2005 in Icelandic inflation-linked bonds, but these can often be profitable trades, as skill in managing opportunistic investments in less-followed and less-efficient markets helps give this team an edge.PAGEBREAK

Common Themes
As we can see, manager experience and a distinctive approach can set some funds apart in the international fixed-income universe. Another important factor, of course, is low expenses. While international bond funds tend to be a bit pricier than their domestic counterparts, all the funds listed above have below-median costs in their respective categories, and two fall in their group's lowest quartile--Oppenheimer International Bond for front-load world-bond funds and T. Rowe Price International Bond for no-load world-bond funds. These funds' modest expenses help management achieve solid performance without needing to take on excessive risk to overcome high fees.

That being said, investors should also remain aware of the various currency, credit, and country risks the funds take on and should not look to these options for short-term gain. This is particularly true now, as the world-bond category has outperformed most domestic-bond categories in the past few years, suggesting investors should temper their short-term expectations.

Lawrence Jones is an analyst with Morningstar.

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