A Spotlight on World-Bond Funds

The world-bond category has been one of the fastest-growing fixed-income groups in recent years, both in terms of assets and the number of offerings. Over the past five years, it attracted a lot of new money, ranking fifth after the nontraditional, bank loan, short-term, and ultrashort categories in terms of inflows. As often happens with faster-growing areas of the market, fund companies were quite active in launching new offerings. Nearly 40% of world-bond funds were launched during the period, bringing the total to just under 100 today.

As a result, investors have to contend with a lot of young and unproven choices, not to mention a wide variety of approaches. Some world-bond funds exclude U.S. debt while others are truly global, and there are many levels of emerging-markets exposure within the category. Corporate bonds may play a significant role in some portfolios, while some funds stick exclusively to sovereign debt.

Currency policies can also differ. While some funds remain unhedged, thereby offering exposure to the currencies of their underlying bonds, several offerings in this group hedge all of their non-U.S. currency exposure back to the U.S. dollar. Still others take an active approach to managing currencies. For instance, a manager may own sovereign debt denominated in euros but will hedge that euro exposure back to the U.S. dollar because of an unfavorable outlook for the euro. And some managers who are bearish on certain currencies can actively short them.

These issues are important to consider when deciding if a particular world-bond fund is the right portfolio fit from a regional, currency, and sector perspective. It's also critical to keep in mind the potentially very different risk profiles that result from the various approaches.

The Risky End of the Spectrum
Some investors, for example, might not be able to stomach the more equitylike performance of certain funds in this category. Among those that have been around for at least five years,  Templeton Global Total Return (TGTRX) and  Templeton Global Bond (TPINX) have the highest correlation to the S&P 500, according to Morningstar data. The performance of  Loomis Sayles Global Bond (LSGBX) and  Oppenheimer International Bond (OIBAX) has also been more equitylike compared with the majority of their peers.

These offerings share a significant focus on emerging-markets debt and currencies, which can experience painful sell-offs when investors flee to assets perceived as being safer. A good example occurred during 2011's rocky third quarter, when these funds slid between 3.4% to 7.9%, landing in the category's bottom quartile, and well behind the 1% gain of the Barclays Global Aggregate Index, a commonly used benchmark in this universe. Looking at these funds through the standard-deviation lens, they've experience roughly two thirds of the volatility of the S&P 500 and about 1.5 times the volatility of the Barclays Global Aggregate.

Not Rocking the Boat
By contrast, offerings in this category that have had very low correlations to the S&P 500 over that third-quarter 2011 stretch include  PIMCO Foreign Bond (USD-Hedged) (PFORX),  PIMCO Global Bond (USD-Hedged) (PGBIX),  DFA Five-Year Global Fixed-Income (DFGBX), and  DFA Two-Year Global Fixed-Income (DFGFX). These funds offer tamer profiles in one or more respects. They focus more exclusively on developed markets and have higher credit-quality and shorter-duration profiles than many peers'. Plus, these funds' policies of hedging all of their currency exposures back to the U.S. dollar has helped them stay more resilient in risk-off markets.

During the five-year period through March 31, 2014, these funds experienced higher correlations to the Barclays U.S. Aggregate Bond Index than most in the category and were at a level closer to the typical U.S. intermediate-term bond fund as well. In terms of volatility, their standard deviations were less than a fourth of the S&P 500's and ranged from 10% to 70% of the Barclays Global Aggregate.

Best Fit
In the end, world-bond funds are best-suited for investors with U.S.-heavy fixed-income portfolios. Those who already own more wide-ranging core bond funds should consider these options carefully because they may already have plenty of exposure to the sectors and regions in many world-bond portfolios. (They should also investigate thoroughly when it comes to the funds that lack much of a track record.) The other important question to ask is whether the goal is total return or steadier results with limited downside risk.

Click here for a list of world-bond funds with Morningstar Analyst Ratings of Gold, Silver, or Bronze. (The list also includes Medalists in the emerging-markets bond category, which were not highlighted in this article.)