Will These Bond Funds Star in a Greek Tragedy?

Greece hasn't typically been a country at the forefront of the world economy, but in recent weeks it has been making a lot of financial headlines. In late 2009, Greece announced that it had underestimated the size of its deficit, and then in early February of this year, fears began spreading that Greece might default on its sovereign debt (bonds issued by the Greek government), causing the cost of insuring that debt against default to skyrocket.

Although the immediate crisis eased when other European Union countries agreed to support Greek debt, the incident has put a spotlight on the problems of Greece and other debt-laden countries in the euro zone, especially Italy, Portugal, Spain, and Ireland. These five economies at the periphery of western Europe have been especially hard-hit by the financial crisis, and European authorities are now trying to help them stay fiscally sound without causing too many unintended consequences elsewhere. All this has put a strain on the euro, which all five of these countries use, and which has dropped in value relative to the U.S. dollar.

It remains to be seen exactly how widely this crisis will affect mutual fund investors; that depends on whether the problems can be contained to these few countries, or whether they're the tip of the proverbial iceberg, like the subprime mortgage crisis that emerged almost three years ago. We dug into our database to identify funds that could be directly affected--namely bond funds with exposure to bonds from Greece, Portugal, Italy, Ireland, and Spain. Of funds actively covered by Morningstar analysts, the following four, all of which are in the world-bond category, have the highest combined percentage of their bond portfolios in those five countries.

 American Century International Bond  focuses on nondollar-denominated bonds from Europe and Japan, mostly sovereign debt but with some corporate bonds. The managers try to avoid credit risk, so that about 75% of the portfolio is rated AAA, and the fund's average credit quality is among the highest in the world-bond category. Nevertheless, while the fund has avoided Greece, 16.3% of its bond holdings (as of Dec. 31, 2009) are from the other four European periphery economies, the highest percentage of any fund our analysts cover.

 T. Rowe Price International Bond (RPIBX) is another fund that mostly owns nondollar-denominated investment-grade bonds from developed markets, though manager Ian Kelson typically holds some high-yield and emerging-market bonds as well. As of December 31, about 10.0% of the portfolio was in bonds from the European periphery economies, including 6.06% in Italian sovereign debt and 1.78% in Greek sovereign debt.

 Oppenheimer International Bond (OIBAX) has historically been more willing than the two funds previously mentioned to take on credit risk; it holds more lower-grade and nonrated bonds than the typical world-bond fund, and manager Art Steinmetz has often made significant forays into emerging markets. Those features helped it post some of the world-bond category's best returns from 2003 through 2007, when emerging-markets debt was red-hot, but thanks to Steinmetz's fine risk controls, it also held up fairly well in 2008. As of Sept. 30, 2009, almost 10% of the fund's bond portfolio was in bonds from the five countries in question, mainly Italian and Greek sovereign debt, though Steinmetz has since eliminated the fund's Greek exposure.

 Evergreen International Bond  is another fund with a generally cautious strategy that emphasizes risk management. The portfolio tends to have less credit risk than the average world-bond fund, though managers Tony Norris and Peter Wilson hold more corporate bonds than their typical peer, and they often make currency and country bets. They've pointedly avoided debt from Greece, Ireland, and Portugal, but sovereign bonds from Italy and Spain were among the fund's 20 largest holdings as of Dec. 31, 2009.

These funds all sport good-to-excellent long-term records, and the T. Rowe Price fund is a Fund Analyst Pick in the world-bond category. Nevertheless, they've been lagging in the first two months of 2010, with the American Century, T. Rowe, and Oppenheimer funds all ranking in the category's bottom quartile for the year to date as of February 25. At first glance, it seems that their exposure to sovereign debt of Greece, Italy, and the other periphery economies might have something to do with that, but other factors, especially currency, have likely been more important. According to Barclays Capital, Greek sovereign bonds have declined in value about 2.8% so far this year on an unhedged basis, but Portuguese bonds have declined only 0.5%, and Spanish and Italian bonds have actually gone up, though by less than other Eurozone sovereign bonds. On the other hand, the euro has declined nearly 6.0% versus the U.S. dollar over the same period, meaning that world-bond funds with a lot of unhedged euro exposure--a group that includes all four of the aforementioned funds--have suffered.

So it's probably not worth worrying about too much if your bond fund has some exposure to Greece and other European countries on shaky fiscal ground. Even with all the recent turmoil, currency is a more important factor in the short term, and in any case these funds' country exposures may have changed since their most recent portfolio. Funds with a lot of unhedged exposure to the euro and other non-dollar currencies are always going to be subject to short-term volatility, but it's best to look past that and consider how a fund has performed over longer time frames.