Go Global for True Fixed-Income Diversification

While investors often seek out exposure to foreign stocks when they're building portfolios, they overlook foreign bonds. Foreign-bond funds can be volatile, but they also provide substantial benefits. Foreign government and corporate debt typically offer higher yields to compensate for their perceived additional risks over their United States counterparts; in fact, yields on emerging-markets bonds in particular can be extremely juicy. Also, exposure to foreign governments and companies, as well as foreign currencies, can further diversify an investor's portfolio and can lower the correlations among investments.

A Cure for Dollar Doldrums?
As the dollar has declined in 2009 against the euro and pound, and emerging markets have rebounded sharply this year, foreign bonds have performed a lot better. Thus, they're not necessarily screaming values at the moment. However, as a number of equity-fund and bond-fund managers at Morningstar's annual investment conference earlier this year stated, the U.S. could very well endure a period of both slower economic growth (due to the massive deleveraging of the financial system) and higher inflation due to government stimulus programs and higher spending. So, many managers are looking beyond U.S. borders.

Steve Leuthold, longtime manager of  Leuthold Core Investment (LCORX) and head of a firm that has specialized in asset allocation for more than 25 years, is particularly concerned about inflation in the U.S. (which has implemented more substantial stimulus programs than other countries). As a result, he's boosted his fund's stakes in both foreign stocks and foreign bonds to historically high levels. In particular, he's added exposure to bonds issued by Asian governments and Brazil, because he thinks those economies (and currencies) will fare relatively well.

Go Global
Our world-bond Fund Analyst Picks include  Loomis Sayles Global Bond (LSGLX),  PIMCO Foreign Bond Hedged  (which hedges its foreign-currency exposure back to the U.S. dollar),  PIMCO Foreign Bond Unhedged ,  T. Rowe Price International Bond (RPIBX), and  Templeton Global Bond (TPINX). They take on varying amounts of credit and currency risk. The Templeton fund, for example, is pretty adventurous when it comes to bets on emerging markets and foreign currencies. The PIMCO funds, on the other hand, tend to limit their exposure to emerging markets and lower-rated debt (and the Hedged fund greatly limits its exposure to currencies other than the U.S. dollar and has been significantly less volatile than its typical category rival as a result).

In general, the managers of our world-bond picks are, like Leuthold, optimistic about emerging-markets debt. Its remarkable run from late 1998 through mid-2008 (before a significant decline through early 2009) may be hard to repeat because yields aren't as fat as they once were. For example, the yield spread between Barclays' emerging-markets bond index and its aggregate bond index was 5.4% in August 2001; that premium shrank to 3.1% by Oct. 7, 2009, as the absolute yield dropped from 12.3% to 6.5%.

Hang On to Your Hats
Nevertheless a solid, dedicated emerging-markets bond fund such as  Fidelity New Markets Income (FNMIX) can be a palatable option for investors with strong stomachs to ride out the bumps. Even better from a risk/reward standpoint is the idea of investing with an experienced management team that can make better choices from bonds across the globe. The ride such a fund offers shouldn't be as wild. That includes our world-bond picks as well as proven multisector bond funds with a record of success overseas, such as  Loomis Sayles Bond (LSBRX). That said, investors will still need to maintain a long-term view, particularly because currencies' short-term movements are notoriously difficult to predict.

A version of this article appeared in the September 2009 issue of Morningstar FundInvestor.