Most international bond funds are focused on developed markets. Emerging market exposure can only be seriously achieved through dedicated funds. And global funds provide access across developed markets, including the United States.
Investors can buy into three types of funds. The largest are open-ended (www.morningstar.com). A sample listed in Figure 3 shows funds that have been able to deliver consistent profitability. Initial investment requirements are modest. Credit quality of investments varies widely. It's easy to mistake a high-grade fund company name with an investment-grade portfolio. It's not unusual to find an average portfolio grade of 'BB,' and with this status can come greater volatility.
Like their equity brethren, many bond funds closely track their benchmark weightings, which are based on the size of each country's debt offerings. This has two immediate implications. One, investors may be paying higher annual expenses, and in some instances sales loads, than lower-cost ETFs that provide comparable exposure to a benchmark. And two, maintaining such market weightings may not make sense.
For example, at 23%, Japan makes up the largest country constituent of the S&P/Citigroup International Treasury Index. For years, Japanese bonds have been the lowest-yielding developed market bonds. The rally of the yen in 2010 has turned this anemic exposure dynamic. And with the yen trading at nearly 80 to the dollar, it may make sense to take some profits. But many managers are staying put.
The second fund type is actively managed closed-end funds (www.cefconnect.com). They vary from open-end funds in two basic ways. One, they often employ leverage to boost returns. This will likely increase volatility and, as the recent credit crisis showed, expose funds to added risks when they cannot refinance their leverage. The second difference: Closed-end funds trade at premiums or discounts to their underlying bond values as investor demand for the funds fluctuates. This adds further volatility, risk and opportunity.
The third fund type is exchange-traded funds that track bond indices, providing exposure to this asset class at less than half the annual expense of open-end funds (www.etfscreen.com). This is an evolving group of funds, whose expansion is in response to strong foreign bond performance. They can offer inverse index exposure through shorting.
Key to selecting the right mutual fund is discerning what is driving profitability and how managers are handling risk. Long-term performance is certainly a positive indicator. But it may have been bought with significant volatility that may not sit well with clients, especially since the trick of realizing these managers' gains is sticking with them during the difficult times.
Caveat
We are in a strange interest-rate environment where developed market yields are at historic lows and faith in emerging economies may be exceeding prudence. A diversified portfolio is essential for weathering what is to come. Christopher Diaz, co-portfolio manager of the $515 million ING Global Bond Fund, which was up more than 11% annually over the past three years, thinks the recent run of high annual total return is coming to an end; he projects high-single-digit returns going forward.
Though it's not likely to happen soon, Sara Zervos believes there is significant risk if the United States starts bumping up interest rates. "Not only would this likely send more assets back to the states, but foreign bond prices-which are based on spreads above U.S. Treasuries-would likely trend lower."
Developed markets could slip back into recession. If that happens, repairing the most seriously troubled government imbalances may be difficult. This would likely send the cost of borrowing higher and the price of bonds lower.