With the Fed's latest round of quantitative easing threatening to push bond yields to historic lows, the domestic bond market is looking less and less attractive to fixed-income investors. "The Fed has put investors in a really difficult position in an effort to try to bolster the U.S. economy," Morningstar mutual fund analyst Kevin McDevitt says. As the Fed has poured money into the system by buying government bonds, interest rates have dropped—a good thing for borrowers because it costs less to borrow money, but a bad thing for lenders such as bond investors, who won't get as much return on their money.
Although interest rates are near zero in the United States, there are plenty of brighter spots in the world for fixed-income investors. In many cases, experts say asset classes such as emerging markets debt and world bonds offer better yields without tacking on a ton of risk. We asked a few bond experts to weigh in on the best ways to play the foreign bond market in your portfolio.
Mutual funds. With mutual funds, you can leave tricky investment decisions to the professionals, and spread your bond bets among many countries and sectors all in one fell swoop. McDevitt recommends the Templeton Global Total Return fund (TGTRX), because of its broad diversification across countries and currencies. Also, the fund's go-anywhere strategy allows it to take advantage of different interest rate cycles and currency valuations, says fund manager Michael Hasenstab, which helps fend off the effects of inflation and a weakening dollar back home. The substantial exposure to high-yield corporate bonds courts a bit more risk for the fund, McDevitt says, but more conservative investors may choose a sister fund, the Templeton Global Bond (TPINX), which primarily sticks to less risky government bonds.
Another fund McDevitt likes is PIMCO Global Advantage Strategy (PGSDX). Unlike most world bond funds, the Global Advantage Strategy fund focuses on countries with relatively low debt-to-GDP ratios, which in some ways makes it a more conservative pick, McDevitt says. The fund has some exposure to emerging markets—right now, those countries tend to fall in the lower debt-to-GDP range—which can turn up the volatility. The fund could be hurt if there's a capital flight from emerging markets, McDevitt cautions, but over the long term, it's a sensible option.
Exchange-Traded Funds. ETFs offer investors stakes in hundreds of different bonds, and because most track indexes, they're usually cheaper to own than mutual funds. Oliver Pursche, president of New York-based Gary Goldberg Financial Services, recommends SPDR DeutscheBank International Inflation-Protected Bond fund (WIP). The fund not only provides inflation-protection by investing in U.S.-inflation linked bonds, it offers a hedge against the falling dollar because it invests in local currencies. Some 80 percent of its bonds are A-rated or better and the average bond duration is less than 10 years—two factors that Pursche says keep volatility in check. Also, the fund's top three holdings by country are the U.K., France, and Japan, none of which are at immediate risk for default. "In our view, we want to be on the more conservative side of the investment," Pursche says. However, the fund doesn't hedge underlying bonds for currency exposure, so returns might be affected by changes in exchanges rates.
For exposure to some of the faster-growing countries within the emerging markets, Pursche suggests PowerShares Emerging Markets Sovereign Debt fund (PCY), because of its exposure to Latin America and parts of Asia. "You're getting a concentrated exposure to the two regions of the world within the emerging markets space that are most stable and growing the fastest," he says. The fund only owns dollar-denominated bonds, so there's no direct currency risk involved (other than, of course, a falling dollar) and lower debt-to-GDP levels in emerging markets countries makes defaults less likely. All around, this fund provides "low-cost exposure to a basket of emerging-markets government bonds," says Morningstar analyst Timothy Strauts.
Since emerging markets have experienced a strong run-up, Pursche and McDevitt advise erring on the side of caution when investing in these fickle markets. Not only are emerging markets inherently more volatile and risky than developed markets, the number of investors piling into emerging market debt and world bond funds has driven up bond prices. "The cat's out of the bag," McDevitt says. "There are a lot of people with the same idea and none of the options are that great." Still, emerging markets and non-dollar denominated debt might end up being the lesser of two evils after the Fed completes its latest round of quantitative easing, especially if the dollar continues to weaken against foreign currencies.