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.

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?

Mariappa of the PIMCO Global Bond Fund typically sticks close to the country weightings that make up the J.P. Morgan Global Government Bond Index. But he boosts the yield on the fund by making small adjustments to the portfolio weightings. The fund, which currently yields a modest 3.5%, invests only in AAA-rated sovereign credits. The yield may not be higher than that of his peers, but he sees his holdings appreciating as the euro strengthens against the dollar.

Mariappa also favors euro-zone bonds. Unlike others, he's loaded up on German bonds. The country is experiencing stagflation-recession and high inflation-resulting from high labor costs. German joblessness hit 10% at the end of 2002.

One of the greatest problems in the euro zone is the inflexibility of Germany's labor and product markets. When business slows, companies can't cut wages due to rigid labor agreements. And corporations have trouble cutting prices to spur sales.

Europe also may flirt with a double-dip recession because corporations have just begun to retrench. Plus, Europe is plagued with weak banks and insurance companies. "Europe needs a recession to force structural reforms," Mariappa says. "European bonds are yielding 60 basis points over U.S. Treasuries. Five-year German Bunds (German government bonds) yield over 80 basis points more than five-year Treasuries. Future rate cuts by the ECB (European Central Bank) will result in European bonds outperforming U.S. bonds this year."

Mariappa is less sanguine about the decline in the dollar. He sees the dollar dropping about 5% against the euro. The reason: Higher U.S. rates also will keep the dollar stronger than expected. He is underweighted in Japan and Asia. In Japan, the central bank's decision to purchase banks' stock holdings is expected to increase the money supply. Therefore, inflation could be a negative influence on the government bond market. Plus, the Japanese government bond market is richly valued, with five-year bonds yielding less than 30 basis points. So he is avoiding positions under three years and is underweighting bonds beyond five years. Asian bonds, he says, are overpriced.

He also is underweight in the United States. The fund has only 25% of its assets invested in U.S government securities and mortgage-backed bonds with short durations.