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World-Bond Funds: 2 Risks to Be Aware Of

Investors should be aware of the currency risk and emerging-markets exposure before investing, as those factors can greatly impact the fund's risk/reward profile.

Karin Anderson: There are about 110 funds in Morningstar's world-bond category, including open-end and exchange-traded offerings. There are a variety of different approaches at play. Some key things to think about are global versus non-U.S. focus, the currency policy (whether the fund is unhedged or U.S. dollar hedged), and also sector exposure.

This year, performance-wise, global versus non-U.S. focus didn't matter so much. What really drove returns so far this year was the currency approach used. Unhedged funds take on the most non-U.S. currency risk because they are giving investors exposure to the currencies of the bonds the funds invest in. With the dollar being very strong this year, similar to last year, that gave the U.S. dollar-hedged funds a clear leg up. On average through Nov. 20, U.S. dollar-hedged funds are up about 1%, compared with an average loss of about 5% for unhedged funds.

There are a number of key risks to keep in mind when selecting a world-bond fund. The first is currency. Unhedged and tactically hedged funds are carrying the most currency risk and, over time, U.S. dollar-hedged funds have shown about half the volatility of those other two types--just to give you some idea. You really want to be careful in selecting an active manager and make sure that they are adding value in a tactically hedged fund or understand the risks that you're taking with a fully unhedged strategy.

The second thing to think about is emerging-markets risk. It's very common to see 10% of these funds invested in emerging markets, but that can go as high as 40% to 50%, which can really change the risk/reward profile.