Thanks largely to the falling dollar, international bond mutual funds have been the shining stars of mutual funds since the stock market peaked in late August. But that makes some experts wonder whether these funds may soon lose their glitter.
The funds--most less than a year old--invest primarily in foreign bonds, with some investing in U.S. bonds as well. As such, they can gain in any of three ways.
First, they gain from interest yield on the bonds. That can range from 4.7% for 10-year Japanese government bonds to 14.9% for five-year New Zealand government bonds. Second, they can profit from lower interest rates overseas, which boost bond prices just as lower U.S. interest rates aid domestic bonds.
Third, and most important, they benefit from the rising value of foreign currencies relative to the dollar. Foreign bonds, like any item denominated in foreign currencies, gain value when those currencies rise relative to the dollar.
Such funds are good "if you are looking for a place more interesting to park your money than a money market fund, without having to play equities," says William E. Donoghue, publisher of Donoghue's Moneyletter, a Holliston, Mass., newsletter.
For most of this year, all three factors have worked in favor of international bond funds. As a result, they are up 17.58% for the year to date through Thursday, making them the third-best performing fund group following gold funds (up 36.68%) and option growth funds (up 30.49%), according to Lipper Analytical Services, a New York firm that tracks mutual funds. Since late August international bond funds are up 8.18%, the only group to post positive returns in that period.
By contrast, international stock funds, which invest in foreign equities, are up 11.87% this year, as declines in stocks worldwide wiped out some of the currency-related gains. All equity funds on average are up 0.17% so far this year.
No wonder investors have been flocking into international bond funds, viewing them as a safer alternative to stocks and as a play on the falling dollar. Assets in the funds have ballooned to $1.9 billion, versus only $352 million a year ago. The number of international bond funds has rocketed to 25 from only five a year ago.
Whether their impressive performance can be sustained, however, depends largely on whether the dollar continues to fall.
Most economists believe that it will, because progress on cutting the U.S. trade and budget deficits will continue to be slow. Edward A. Taber III, portfolio manager of the T. Rowe Price International Bond Fund, says he won't be surprised if the dollar falls 10% to 15% during the next year.
Some overseas interest rates also could decline further, says Leslie J. Nanberg, manager of Massachusetts Financial International Trust--Bond Portfolio, the oldest international bond fund. Foreign central banks, he says, have become more concerned about recession than inflation. So they will be more inclined to pursue easy money policies, which drive down interest rates.
But others are not so sure. Easier money may initially drive down interest rates but will eventually produce higher inflation, which in turn will push interest rates higher, argues Michael D. Hirsch, who manages mutual fund portfolios at Republic National Bank of New York. "You could have a double whammy," Hirsch says of the adverse effect of higher inflation and interest rates on international bond funds.
Some economists also disagree with conventional wisdom and contend that the dollar is poised to rally. "Everybody's so negative on the dollar--I think it's probably bottomed out," says A. Gary Shilling, a New York economic consultant.
If the dollar rebounds, the key to whether the funds can continue their strong performances depends largely on how well they hedge foreign currency risks and shift their portfolios into dollar-denominated bonds.
For example, when the dollar rallied in late spring and summer this year, the T. Rowe Price fund shifted into dollar-denominated bonds as well as into bonds denominated in currencies that also do well when the dollar is rallying, such as the Spanish peseta and the Italian lira, Taber said. Accordingly, the fund maintained its strong returns, he said.
But if funds miscalculate, they could actually post negative total returns, because so much of their gains have derived from the falling dollar rather than interest yields. A turnaround in the dollar thus could easily offset yield gains.
One example of such potential risk is Global Cash Portfolio, an international money market fund investing in U.S. and foreign short-term credit instruments. Only about 4% of its 22.1% total return in the past year came from interest earnings. The rest was from rising foreign currencies.
Recession a Factor
"If we get it wrong . . . it could more than offset the current yield," acknowledges Donald P. Gould, president of Huntington Advisers, a Pasadena firm that offers Global Cash Portfolio and several other foreign money market funds.