5 World Bond Funds That Diversify and Cut Risk

Global investments mitigate the risks of countries defaulting on their debt.

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As the global economy digs out of the financial crisis, investors may be wondering where in the world to put their money. For fixed-income investors, world bond funds offer diversification with investments in a broad range of different countries and sectors, mitigating the risks involved if some countries default on their debt.

[See U.S. News’s list of the Best Mutual Funds for 2010 and use our Mutual Fund Score to find the best investments for you.]

The Federal Reserve on Wednesday ended its massive mortgage buying program, fueling a rally in the bond markets and attracting investors. But some experts think the rally might be over. “I think it remains to be seen what the effect is, but so far, so good,” says Ken Buntrock, co-manager of the Loomis Sayles Global Bond Fund. “This is just one of several programs that the government did, and they’re slowly withdrawing this liquidity from the marketplace.” If the economy and housing markets recover, the Federal Reserve could raise interest rates—but that won’t be until at least the beginning of 2011, Buntrock says. In Europe, the situation is more dire. Greece and Portugal have seen their debt downgraded, and there are even concerns that the European Union and the International Monetary Fund will have to bail Greece out so that the country doesn’t default on its debt. The amount of sovereign debt—or debt issued by governments—is a growing concern in many developed nations.

[See How Greece’s Debt Crises Affects America.]

If investors buy bond funds that exclusively focus on the U.S., they may be missing out on opportunities elsewhere. “Global bond funds can be a very important piece of your portfolio because you’re going to get exposure around the globe for various types of growth, wherever growth might occur,” says Andrew Gotfried, director of mutual fund research for Raymond James. “We like global bond funds because to go and get the fixed-income vehicles around the globe individually is very difficult for the average investor, and the global bond fund is a great vehicle to get that kind of exposure.”

Many fund managers have ramped up their emerging markets exposure significantly—some have even begun to invest in them exclusively—because they say these countries look healthier coming out of the crisis, with less amounts of debt than many developed countries. Government bonds of countries like the U.S. and the U.K. have long been considered among the safest bond investments available, but their growing deficits have many experts worried. “We do think long term that there’s going to be a passing of the torch from the developed world to the developing world,” says Chris Diaz, co-manager of ING Global Bond fund. “It’s going to be a slow and not a very robust recovery for much of the developing world, so we’re trying to capitalize on that by having exposure to high-quality emerging markets and countries that benefit from strong growth in those places.”

The effects of ballooning deficits in some developing countries could have far-reaching effects. Some managers say investors are underestimating the size and importance of these sovereign debt issues. “In many asset classes, investors have only just begun to think about this increasing sovereign risk factor, which we think will be driving a lot of markets going forward—not just bond markets—but other risk markets like even equities,” says Scott Mather, manager of PIMCO Global Bond fund. “Investors are simply not used to having to think about these sovereign debt dynamics and are probably underestimating the risks involved for many countries going forward.”

With that in mind, here is a list of five world bond funds that have received high marks within the world-bond category, according to U.S. News’s Mutual Fund Score

ING Global Bond (symbol INGBX). Before the financial crisis, this fund loaded up on sovereign debt, and as a result sidestepped the carnage within the corporate and mortgage-backed sectors. Management generally favors investment-grade debt and invests in local currencies. Diaz says the fund’s portfolio includes sovereign debt, investment-grade corporate IOUs, high-yield bonds, and mortgage-backed securities. The fund has a significant weighting in the U.S. because management currently favors the U.S. dollar as opposed to the British pound or the Japanese yen. “People ask why we like the dollar given all the problems that we have,” Diaz says. “My answer is it’s the best of a lot of poor choices.” Within the U.S., management is focusing on corporate bonds and high-yield bonds and avoiding investments in the Eurozone because of trouble in countries like Greece. Instead, the managers are looking to emerging markets—particularly the BRIC countries (Brazil, Russia, India and China) and Indonesia—for growth.

PIMCO Global Bond (PIGLX). The managers of this fund scour the globe for countries with the best debt dynamics moving forward, including Germany, Australia, and Canada. “The focus is on quality,” Mather says. “This is a time for investors we think to be very discriminating rather than trying to move down in quality to pick up extra yield.” Mather is also keen on government-guaranteed financials bonds. These investments came about after governments throughout the developed world intervened in the financial sector and, in effect, guaranteed the debt of some troubled financial companies. The appeal of these bonds, Mather says, is that they are high-quality investments with more growth potential than most sovereign debt.

Dreyfus/Standish Global Fixed Income (SDGIX). The managers of this fund invest primarily in corporate bonds and focus less on sovereign debt. Corporate bonds currently account for about half of the fund’s assets, while sovereign debt makes up less than 20 percent. “We do hedge most of the currency risk back to the dollar so you get a bond return type fund without the volatility that can come from buying non-U.S. investments because we hedge those risks away,” says co-manager Dave Leduc. Most of the fund’s investments in government securities are in countries like Japan, the U.K., Sweden, and France.

Loomis Sayles Global Bond (LSGBX). Co-manager Ken Buntrock says it’s “an upside down world right now,” because many countries like Mexico and Indonesia that management once avoided are now areas where his team looks to invest. “The formerly high-quality sovereigns are suffering from pressure on their fiscal balances and probably at some point on their ratings, and in the meantime, some of the emerging markets are enjoying ratings upgrades like Brazil,” he says. The fund is currently overweighting currencies including the Canadian dollar and the Mexican peso, and like many other funds, is focusing on corporate and high-yield bonds because of sovereign debt concerns. Buntrock adds that management is also pursuing what he calls the “emerging tigers,” including Singapore and Korea.

Templeton Global Bond (TPINX). Manager Michael Hasenstab is betting big on emerging markets. As of the beginning of February, his fund had no exposure to sovereign debt in the U.S, U.K., or Japan. The fund is also underweight in the Eurozone, with only a small investment in Germany. More than half of the fund’s total assets are dedicated to emerging markets because he has less concern about their debt than he does about the debt of developed countries. “While emerging markets suffered from the collapse in global trade earlier this year, their economies tend to be healthier and their financial systems stronger and un-impaired, in contrast to their developed markets counterparts,” Hasenstab wrote in a statement.