June 2005, Investment Advisor

Advisors traditionally think of U.S. high-grade bonds as secure, predictable plays for the conservative investor. Well, think again.

For more than a year, shorter-term Treasuries have been generating negative real yields. In February, six-month notes were paying less than 1 percent per annum, and two-year paper just1.71 percent, both below the rate of inflation. Three-year bonds weren’t offering much more, paying 2.24 percent. Five-year bonds were barely yielding 3 percent, and 10-year Treasuries were offering a smidgen over 4 percent, begging the question: What’s the point?

Corporate debt isn’t much better. According to Morgan Stanley, quality investment-grade debt has been yielding about 100 basis points above Treasuries across much of the yield curve. Investors with an appetite for more risk might receive a meager 100 basis points extra for venturing into the high-yield arena.

Why the low returns? David Wakefield, London-based portfolio manager of Delaware International’s Global Fixed Income Pool Trust, explains that as the Federal Reserve has pushed U.S. interest rates to 40-year lows, the search for yield has produced a feeding frenzy for anything with a halfway decent coupon. “The result,” he observes, “has been a compression of spreads that barely differentiates risk.”

Adding further bleakness to the fixed-income picture is the simple fact that interest rates have only one way to go. And according to many observers, that move upwards is likely to begin sometime this year as the U.S. economy builds momentum and rising rates start to pummel much of the bond market.

So should you avoid fixed income? Absolutely not. As the recent three-year bear market has reminded us, there is no substitution for proper asset allocation. But where can one find bonds that aren’t on the wrong side of the interest-rate cycle? How about offshore?

Many money managers still look at foreign investing as alien, risky or simply unpatriotic. But the plain truth is that despite the U.S. being the strongest and most affluent nation on earth, superior securities can often be found elsewhere. And this is no truer than in the debt market.

According to PIMCO’s global bond strategist, Sudi Mariappa, the same concept of the efficient frontier”that suggests how a globally balanced equity portfolio reduces volatility while increasing returns applies as well to bonds. Moreover, says Aran Gordon, fixed income vice president at T. Rowe Price in Baltimore, there is virtually no correlation these days between the J.P. Morgan Non-U.S. Global Bond Index and Lehman Brothers Aggregate Bond Index. “Since 1986,’ Gordon observes, “we’ve seen five complete cycles in which foreign bonds [in dollar terms] topped U.S. debt then followed by a period of U.S. outperformance. These fairly well delineated cycles lasted from one-and-one-half to five years.” And technically, at this moment, it would appear that foreign bonds are poised to outperform U.S. bonds for a while longer.

But another factor suggests that right now foreign bonds are offering U.S. investors a unique opportunity. “It is quite rare to find large interest rates spreads between solid economies coupled with a weakening U.S. dollar,” observes Ruggero de Rossi, New York-based portfolio manager of the Oppenheimer International Bond Fund. “And that’s why global bond funds have been performing so well over the past several years.”

According to Morningstar, U.S.-based global bond funds have gained at an annualized rate of 9.47 percent over the three years through the end of February. That’s 3.25 percentage points better than domestic bond funds. And for those with a strong equity bias, global bond funds trumped the S&P 500 by more than 11 points a year since March, 2001, despite the blowout year stocks enjoyed in 2003.

A number of top-performing bond funds have averaged 20 percent gains over each of the past two years, including Wakefield’s Delaware Pooled International Fixed-Income Trust, Templeton Global Bond, T. Rowe Price International Bond, and de Rossi’s Oppenheimer International Bond fund.

So do these standout performances suggest foreign bonds are now likely to run out of steam and revert to their typically more mild mannered demeanor? Not at least for the near term. Two fundamental forces are at work.

First, a number of solid foreign economies haven’t been dragged through recessions. Nor have they resorted to hyper-fiscal stimulation to promote growth—as the U.S. has done and which eventually may have to be reckoned with in terns of higher inflation.

Take Australia and New Zealand, which have barely missed an economic beat over the past five years. According to the Economist Intelligence Unit, Aussie GDP has expanded by an average of 3.28 percent between 1999 and 2003, and is expected to grow by 3.8 percent this year. But inflation has been averaging 3.24 percent, and is expected to end this year at 3.1 percent, partially explaining the reason that Australian interest rates are higher than America’s. Neighboring New Zealand has been growing even faster, averaging 3.66 percent GDP growth since 1999. This year growth is expected to come in at 3.2 percent. Inflation has been running at 1.9 percent. It is expected to spike a bit over 2 percent in 2004. But aggressive central bank policy has kept interest rates even higher than Australia’s. And another good sign has been the government’s perennial budgetary surpluses.

Waltham, MA-based Global Insight, which tracks macroeconomic trends, observes strong housing markets in both countries, buoyant economies, and mild inflation concerns will likely encourage central banks in both countries to further nudge up interest rates. Expanding the yield spread will further attract foreign assets, likely giving a further boost to local exchange rates over the near term.

Indeed, steady growth in many developed and emerging markets, coupled with rising interest rates, have contributed to a disconnect with the U.S. economy and bond market. If such division continues, it’s possible that by the time the Fed gets around to pushing rates back up to more traditional levels, these countries may be shifting monetary gears into reverse, cutting rates, and sending their bond prices even higher. As Peter Perkins, global investment strategist at BCA Research in Montreal, puts it: “You want to be buying bonds in countries that are closer to the end of the tightening cycle than who are just beginning the process.”

The second force driving returns has been two consecutive years of dollar weakness. Many currency observers, including Chuck Butler, president of Everbank World Markets in St. Louis, suspect this is only the start of a correction that could last several more years.

When a U.S. investor puts money into any foreign security whose underlying currency appreciates against the greenback, the security becomes more valuable. For instance, the Aussie dollar appreciated 34 percent against the greenback in 2003, as the New Zealand’s dollar climbed 25 percent. The euro, meanwhile, gained 16.5 percent, and the British pound climbed 9.8 percent. For bond investors who didn’t hedge away their foreign exchange exposure, those currency gains spelled pure profit.

To be sure, the dollar could suddenly reverse course. But economists argue that the sheer scale of the U.S. current account and budget deficits will likely make any near-term rally in the dollar an ephemeral one. Basic economic principles would dictate that the dollar must weaken for the U.S. to continue to finance its expanding domestic and international gaps. Still, foreign exchange markets are devilishly hard to predict, and have a way of defying even the most unimpeachable logic. Advisors must be mindful of this caveat. Fixed-income clients who don’t want any unexpected risks and are content with just keeping up with inflation should not be in foreign bonds. Unhedged negative currency moves could easily sink a bond investment.

There are four basic types of foreign bonds. The two most secure are generally sovereigns–government bonds–and supranationals, which are issued by organizations such as the World Bank, the International Finance Corporation, and a myriad of regional investment banks backed by governments. Most are highly rated securities offering similar yields.

A number of emerging markets, especially in Latin America, where state debt has been restructured, offer U.S. dollar-denominated Brady bonds. By stripping away the currency risk and with principal and certain interest collateralized by U.S. Treasury zero coupon bonds and other high-grade instruments, these bonds are designed to reduce borrowing costs and attract foreign investors.

There are two types of corporate bonds in global markets: Those issued by foreign-based firms and foreign currency-denominated debt issued by U.S. companies. American firms doing business abroad often borrow in local currencies to finance their operations as well as to diversify their borrowing base. But with investment-grade and junk bonds not offering particularly attractive spreads, Treasuries and supranationals are probably the most attractive foreign debt plays.
Echoing prevailing asset manager sentiment, T. Rowe Price’s Aran Gordon believes that 5 to 10 percent of the average portfolio should be in foreign bonds. But he cautions that advisors shouldn’t focus on yield alone. “Bond performance should be driven by quality developed market debt and augmented through selective investments in special higher risk opportunities,” he says.

Laddering a portfolio of sovereigns with various maturities is a typical way to structure foreign bond exposure. For advisors new to this arena, selecting and managing such a portfolio requires monitoring local economic policies, interest and foreign exchange rates to manage risk.
A fairly simple way to get one’s feet wet may be to start with bonds maturing within one year. These securities are generally more predictable and less vulnerable to changes in central bank policy and foreign exchange rates. But they frequently offer clients greater spreads over comparable U.S. paper. Six-month U.S. Treasuries, for example, earn a total of one-half of one percent. AAA-rated British government debt, known as gilts, would pay four times that. Comparably rated New Zealand Treasuries would yield more than five times U.S. rates.

Venturing into emerging markets pushes up the risk/return picture. Oppenheimer International Bond Fund manager Ruggero de Rossi, for one, has recently begun establishing a position in South African bonds. He sees improved currency risk, enhanced central bank policy that has bolstered foreign exchange reserves, and the prospect that rates could decline during the rest of the year. However, he expects rates to subsequently rise one to two years out. Indeed, six-month A-rated South African sovereigns have an annual yield of 8 percent. Global Insight expects domestic growth, which slowed by half in 2003 to 1.7 percent, to pick up to 2.5 percent in 2004. The Economist Intelligence Unit anticipates even stronger expansion of 3.3 percent. This does suggest that the next move in interest rates is likely to be up, which should help the rand hold steady against the dollar over the near term. At the same time, the value of short-term paper should be sustained by its approaching maturity.

For those with more daring tastes, how about Hungary? The former communist country’s six-month paper is yielding an annualized 12.63 percent and sports an A+ credit rating. In a recent survey of the country, the Organization for Economic Cooperation & Development observed impressive annual economic growth that has averaged 4.25 percent since 1997 driven “by foreign direct investments and rapid integration into European production networks.” But this achievement has been tarnished by massive budget deficits and rising inflation, which have sent interest rates soaring.

However, pending membership into the European Union this spring and Hungary’s preparation for joining Exchange Rate Mechanism II, the precursor for nations wishing to join the euro, will likely induce necessary economic reforms that should strengthen both the economy and the currency.

Tony Norris, chief investment officer of Evergreen International bond fund, finds Hungary’s short-term notes very attractive, with minimal foreign exchange risk. He’s in small company on this play. But he is quick to add that “if the Hungarian forint experiences increased volatility and weakens further, I would be quick to bail out of the position,” highlighting the fact that exchange rate shifts can rapidly erode even the most eye-popping yields. It’s usually the main reason why yields are high in the first place.

Longer term, most observers see Hungarian debt as a “convergence” play, much in the same way Italian, Spanish, Portuguese, and Greek debt was seen in the mid-1990s as their respective governments prepared for euro membership. This scenario proved a trifecta for bond investors: Interest rates plummeted, improved public finances produced higher credit ratings, and the currency strengthened as it prepared to lock into the euro.

While not as efficient as purchasing foreign equities, buying foreign bonds is becoming easier. Most full-service and discount brokerages can fill orders quickly. However, because foreign bonds trade over the counter, it’s hard to discern differences in spreads, transaction costs, and exchange rate fees, all of which can vary widely.

At some brokerages, like Everbank World Markets, these costs are transparent. According to John Kaupisch, head of global bond trading, on a $100,000 order, investors pay a transaction fee of approximately 25 basis points and a comparable amount for foreign exchange. Everbank’s bond prices are quoted inclusive of all costs.

TD Waterhouse, on the other hand, doesn’t break out its costs, and when it priced a 6.5 percent Queensland, Australia, Treasury bond due in June 2005, the quote was 65 basis points higher than Everbank’s. On a short-term bond trading above par, that difference reduced the yield to maturity from 5.18 percent to 4.66 percent.

The advantages of buying individual bonds for your clients is that you know precisely what you own—credit quality, how much it currently pays, when it matures, and total return due upon maturity. If rates go up and the bond value declines, unlike with a mutual fund, investors can simply wait for the bond to mature to fully reclaim principle.

If the investment gets hit by a strengthening U.S. dollar, the underlying value of the bond doesn’t have to be repatriated upon maturity. It can simply be rolled over into a certificate of deposit or short-term bond, which could be held until the currency rebounds. Or one could simply hedge the currency risk from the start.
Direct investment also avoids annual expenses, and front or rear-loaded fees associated with funds. While the difference between these expenses and acquisition and sales costs when buying bonds directly may be minimal for short-term holdings, longer-term investors should save on expenses through direct investment.
Lastly, with closed-end funds, investors could get hit twice when bond prices decline: first, through diminished net asset value; and second, by reduced demand for the fund, further cutting into its market value.

Of the three closed-end funds listed in the accompanying table, Morningstar reports that their market values deviated 10 to 20 percent from their net asset value since the beginning of 2002. And most of the time, deviation was on the negative side of asset price.

Nevertheless, despite their drawbacks, most advisors would probably prefer gaining foreign bond exposure through mutual funds. They can select funds that target emerging or developed markets, high-grade or junk bonds, with hedged or unhedged currency exposure. But advisors must be mindful that most funds can alter these investment strategies at any time.

With a myriad of fund tracking services available, selecting a successful fund can be a lot easier than finding solid bonds. Managers, working with teams of analysts across the globe, are likely to have a better understanding of the fundamentals and nuances of foreign debt and currency markets than most advisors. A fund’s more diversified holdings should help minimize risk. Its value is generally a lot easier to track than that of an individual bond, and trades are easier to execute.
An alternative to foreign debt securities is preferred stock. Global issuers of dollar-denominated preferred shares include major banks such as Dutch ING and ABN-Amro, Spain’s Banco Santander and BBVA, the Royal Bank of Scotland and Abbey National in the United Kingdom, UBS in Switzerland, and Australia’s Westpac. Preferreds’ current yields generally range from 5 to 8 percent, and in contrast with the way bond interest is taxed at ordinary rates, many preferreds qualify for the new low 15 percent U.S. dividend tax rate (Be mindful of trust-backed preferreds which are composed of bonds and therefore pay out interest, not dividends).

Because they are dollar-denominated, these foreign preferred shares are not directly affected by fluctuating foreign exchange rates. Their prices are driven by issues of credit quality, call dates, and duration—just like bonds.

However, the market has discovered these once-obscure investment-grade securities and have pushed prices substantially higher over the past several years. Because many preferreds could be called relatively soon at prices that are up to several hundred basis points below where they currently trade, some yields-to-call are razor thin. In some cases, they are negative. Investors are simply betting that companies will not redeem these shares. You can obtain details on most publicly traded domestic and international preferreds at QuantumOnline.com (www.quantumonline.com/index.cfm).

Certainly, having a call feature doesn’t mean issuers are going to reclaim this capital. But if preferreds were issued when rates were substantially higher, there’s no good reason why they shouldn’t be refinanced at lower rates at the earliest possible moment. And even if they don’t, companies still retain the right to redeem shares on a month-to-month basis after the call date passes.

Whether your choice of instrument is an individual bond, mutual fund, or preferred stock, you and your clients will likely be well served by gaining exposure to credit markets outside the U.S. At a time when the domestic bond market is priced high and bracing for a fall, the wealth of opportunities remaining offshore is impressive indeed.