David Gibbon, manager of the J.P. Morgan-subadvised American Century International Bond Fund, says the macroeconomics favor the European bond market. The fund, which yields 4%, only owns bonds with sovereign debt ratings of AA and AAA by Standard & Poor's.
In the early part of 2002, Gibbon focused on non-core euro-zone countries such as Italy and Spain. But as the outlook for global economic growth stumbled, he shifted into French and German paper. These bonds performed well as the economy slowed.
By mid-2002, the fund was 57% invested in the euro zone. Now he has 74% invested in the region. The euro-zone economy is growing at a paltry 1%. The economic outlook for Europe shows no signs of improvement, which is good for government bonds. An easier monetary policy could be justified to stimulate economic growth, particularly in Germany.
"Germany is extremely weak and European companies are cutting operating expenses," Gibbon says. "Commodity prices are falling and inflation will fall below 2%. That gives the European Central Bank room for more rate cuts."
Gibbon says he does not hedge against changes in foreign currency values, so the fund will benefit from the weakness in the dollar. On the emerging market side, Matt Ryan of the MFS Emerging Debt Fund, says the fundamentals look good. Plus, Standard & Poor's recently increased emerging-market debt ratings to BB from B. The sovereign debt he holds is characterized by flexibility in fiscal and monetary policy, stable foreign direct investment flows, the ability to issue debt, relatively low spreads and the achievement of ever-higher levels of per-capita income.
"Korea, Russia and Mexico have solid fiscal policies," Ryan says. "Russia now has a large fiscal surplus. They have built up foreign exchange reserves. Mexico has prudent policies and an austere fiscal budget."
The fund has 24% of assets invested in Russia, 20% in Mexico, 12% in Brazil and 10% in Bulgaria and Panama. He likes Mexico because of its oil and other export businesses. Exports as a percent of gross domestic product (GDP) have increased dramatically over the past few years. Meanwhile, Russia is diversifying its business mix. It no longer is dependent on oil, and it has insured itself from dropping oil prices by setting up reserves and selling more steel and niche manufacturing products. The fund is underweighted in Brazil. Ryan believes that the new administration is untested, plus the country has a large debt problem. Inflation also is on the rise. He is invested in the most liquid Brazilian bonds in case he must sell them.
Ryan is not investing in Asia because Asian bond-yield spreads in relation to U.S. Treasuries are too narrow. He also is concerned about the impact Brazil's economy will have on the rest of Latin America and South America if events sour. "The biggest risk is Brazil because of their large fiscal deficit and balance-of-payments problems," Ryan says.
Ryan is not concerned, however, about panic selling spreading through emerging markets as it did in the 1990s. At that time, markets in Asia plummeted, followed by markets in the Americas and Eastern Europe. "The economic problems in Argentina and Brazil have not affected prices of other emerging-market bonds today," he says.
Although emerging-market bond funds have grown at double-digit annual rates over the past three years ending in December 2002, they are highly vulnerable to exogenous shocks. In the third quarter of 2002, emerging-market debt prices declined because of investor concerns about decelerating global growth and its impact on the emerging markets. And who can forget that the average emerging-market bond fund lost 23% in 1998, when Russia defaulted on its debt obligations?