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Trip to Bountiful : Global Funds Have Outperformed U.S. Bonds, but Big Gains May Be Over

November 19, 1996|Debora Vrana

Global bond funds, which invest in bonds of companies and countries worldwide, this year have dramatically outperformed funds investing only in U.S. issues.

But the overseas party may soon be over.

Many fund managers expect the U.S. economy will continue to slow next year. That, in turn, will prompt a further decline in interest rates next year, giving a big boost to U.S. bonds, they say. Sharp declines in foreign interest rates, which helped boost the value of foreign bonds this year, may be over, many analysts say.

Still, for some investors, this year has been quite a party.

Overseas bond funds are on track to outperform U.S. bond funds this year by some of the strongest margins in 10 years, analysts say.

World bond funds have posted a 9.85% average total return for the first 10 months of this year, compared with 2.47% for U.S. corporate and government bond funds, said Morningstar Inc. fixed-income analyst Mark Wright. The last time that spread was wider was in 1986, according to the Chicago-based fund tracker.

"The U.S. economy has proved to be much stronger this year than anyone expected," Wright said. "Bonds here got killed. That didn't happen in other countries, many of which are cutting interest rates. Economic trends in foreign economies have been bond-friendly this year."

While U.S. stock prices were climbing to record highs this year, bond prices here overall actually fell as interest rates rose. And investors reacted accordingly. In October alone, an estimated $500 million was withdrawn from long-term bond funds, marking the fourth month in the past six that money has left these funds, according to the Investment Company Institute, an industry trade group in Washington.

The situation for global funds was a little brighter. In September, $65 million of investor cash flowed into global funds, the first positive gain since February, the trade group found. While October estimates aren't yet available, some specialists said there has been more money going to world bond funds in recent weeks as interest rates have tumbled.

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Still, if an investor hasn't already joined the global bond fund bandwagon, it might be too late.

Jonathan Francis, head of global strategy for Putnam Investments in Boston, said the strong performance posted by global funds this year won't be duplicated next year.

"This kind of outperformance has run its course already," Francis said. "So, for 1997, investors should look in their own backyards for bond funds."

Still, you should consider foreign bond funds for their value in diversifying your fixed-income portfolio. Foreign bonds can help reduce the risks associated with interest rate movements, credit quality and inflation associated with a pure U.S. bond portfolio. Historically, having a diversified portfolio of U.S. and world bonds reduces volatility, although foreign bonds as an asset class can be more volatile, managers said.

One option for global bond investing are funds that invest in emerging markets, such as Mexico or Argentina.

"This year is the story of emerging markets. These funds with large exposure to emerging market debt have done especially well," said Janet Yuen, a fixed-income analyst with Lipper Analytical Services in New York.

Some of the best performers so far this year, said Yuen, are Alliance Global Dollar Gov A (current yield of 8.69%; one-year average return of 34.36%) and Merrill Lynch Americas Inc B (current yield of 7.76%; three-year annual average return of 11.09%) with a five-star rating from Morningstar.

Both funds are heavily concentrated in emerging markets. For example, Merrill's fund is more than 16% invested in Argentine bonds and 13.5% invested in Mexican bonds, as of June.

All are also concentrated in so-called Brady bonds, which are IOUs issued by Latin American governments for which Washington has guaranteed the principal repayment and up to three interest payments. Because they are dollar-denominated, the bonds reduce currency risk.

Another option for global funds could be a closed-end foreign bond funds already selling at discounts to their net asset value, says Thomas Connelly, a fee-only certified financial planner in Arizona. With a closed-end fund, investors buy shares in the fund on the stock exchange, much like stocks of a company.

If you're ready to invest in a global bond fund, analysts suggest following these steps:

* Consider the characteristics of the portfolio, such as what country's bonds dominate the holdings. For example, yields on Japanese 10-year bonds right now are as low 2.68%, so if your fund had a large percentage of these bonds, it could be risky as Japanese interest rates are already at historical lows and a substantial rally in that market is unlikely, said one planner.

* Look at the currency hedging policy, a tactic used to reduce the risk that the fund might lose value if the currencies that its bonds are denominated in fall in value. That tactic reduces volatility, but often won't be spelled out enough for investors to understand.

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