Foreign bonds are poised to outperform U.S. issues this year.

Foreign bond funds may produce high yields and positive returns over the next few years. That is in stark contrast to forecasts for U.S. bonds, which are expected to drop in value as interest rates rise from their historically low levels now.

Over the past three years, international and emerging-market bond funds have outperformed domestic bond funds as a result of worldwide interest rate cuts and the declining value of the dollar.

Overseas bond funds appear poised to perform well in 2003 and sport low correlations to U.S. bonds. The average emerging-market bond fund has a zero correlation to the Lehman Brothers Aggregate Bond Index. Meanwhile, foreign bond funds that invest in high-quality sovereign debt have about a 50% correlation to U.S. bonds, according to Morningstar Inc., Chicago.

International bond fund managers say they are earning higher yields on their investments than funds that invest exclusively in domestic bonds. Plus, they believe non-U.S. bonds will appreciate as central banks cut interest rates to spur their economies. For example, Sudi Mariappa, manager of the PIMCO Foreign Bond Fund and the PIMCO Global Bond Fund, believes his funds will register total returns of 10% in 2003.

Art Steinmetz, manager of the Oppenheimer International Bond Fund, is bullish. He typically invests in a combination of high-quality sovereign debt, as well as developing and emerging-market securities. This gives his fund a higher yield, plus the potential for greater capital appreciation than for funds that invest exclusively in industrialized countries. Steinmetz looks for income advantages over the U.S. market. He diversifies by currency and country. The fund was yielding almost 6% in late 2002.

"The rally in U.S. government bonds is over because higher rates are on the horizon over the next 12 months," Steinmetz says. "But emerging-market bonds are going to benefit from the U.S. economic recovery. The real driver in Europe will be the decline in the dollar."

Steinmetz favors investing in non-Middle Eastern oil-producing countries. If we go to war with Iraq, oil prices will shoot up. Even if we don't go to war, a stronger U.S economy will keep oil prices high. As a result, the fund has a large stake in Mexico, Russia, Venezuela and Columbia.

He also owns bonds issued by Guatemala, the Dominican Republic, Chile, Belize and El Salvador. These countries have strong agricultural exports and benefit from tourism. About half the portfolio is invested in Europe. The decline in the dollar should boost the value of euro-denominated bonds. He also expects that the European central bank will cut interest rates in 2003.

The fund has limited exposure in Asia. The reason: Yields are lower. But the fund does own Philippine, Korean and Indonesian bonds. Overall, Asia currencies track the U.S. dollar and bonds are expensive.

If we go to war with Iraq, Steinmetz says he will move out of emerging-market bonds because they are more volatile than bonds issued by industrialized countries.

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