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Your best fixed-income bet is overseas
Traditional lines of research quickly hit a dead end when searching for foreign bond funds, but after a lot of digging, we emerge with a winner.
By Timothy Middleton
A lively debate has sprung up in MSN Moneys Start Investing Community regarding foreign bond funds. Most of us agree foreign government bonds are more attractive now than Treasurys. But finding a fund is tougher than we expected.
Have you looked at the holdings of LSBDX lately? asked a member of the community whose screen name is verrip 1. Although classified by Lipper as a BBB U.S. bond fund, it is currently holding a lot of (emerging market) and other foreign bonds. In the five to six years I've held it, (Canadian) bonds, (especially) zeros, have always been a part of the holdings.
Loomis Sayles Bond Fund (LSBDX), the fund verrip 1 identifies, is what Morningstar classifies as a multi-sector bond fund. You won't find it under foreign bond fund because Morningstar has no such designation. Nor does it have an international bond classification. Just world bond, which, of course, includes the United States.
Thats the unfortunate standard in fund nomenclature. If youre looking for a fund that specializes in foreign bonds and makes a distinction between those of high and low quality, good luck. Ive been working on the problem for several weeks now, combing prospectuses, Web pages and Securities and Exchange Commission filings.
Passing the test
Heres what Ive learned. There are precious few top-performing funds that offer domestic investors the opportunity to take advantage of higher rates overseas, weaker economies putting less upward pressure on rates and a falling dollar.
One of them, as it happens, is a sibling of verrip 1s fund. It's Loomis Sayles Global Bond (LSGLX). As it also happens, Loomis Sayles has been tarred by the brush of the fund industry's scandal, adding another layer to the analysis cake. Though you can never be certain where fraud is concerned, Im satisfied this fund passes the scandal test.
When you search for global income funds, you have to go far beyond a few simple screens. The top prospect in Morningstars world-bond database over the past year is GMO International Bond III (GMIBX), which has a $5 million minimum. The second, Oppenheimer International Bond (OIBAX), invests heavily in emerging markets. These are not high-quality bonds; the average holding of this portfolio is rated triple-B, just one rung above junk.
Lipper, a rival fund analysis firm, has a category called international income, but it leads to the same dead ends as Morningstar. Among the top three names at LipperLeaders.com are the GMO and Oppenheimer portfolios.
The best database Ive found for closed-end funds, ETFConnect.com lists 37 funds in the global fixed-income category, and they're a hodgepodge. Blackrock Income Opportunity (BNA) invests almost entirely in U.S. bonds. Salomon Brothers Global High Income (EHI) invests mainly in junk, half of it in the United States.
Junk bonds are as dangerously expensive as Treasurys now, and a key goal for me in a foreign bond fund is to get a currency kick as the dollar continues to depreciate against other hard currencies, which is likely.
And while I have nothing against emerging-markets bonds, I view them as a separate bet from the sovereign debt of developed nations such as Germany and Japan. Also, most emerging-markets bonds are priced in dollars.
Digging in
Once I had a list of candidates, I went to the SECs excellent Edgar database to review prospectuses and other regulatory filings. Unfortunately, they're not very helpful. The boilerplate legalese of global bond funds is that they're free to invest anywhere and to hedge currency risk if they wish.
Still, I was able to use Edgar and other online databases to winnow down the field of candidates somewhat. A Web site called QuantumOnline.com provides basic research tools that quickly explained why Aberdeen Global Income Fund (FCO), for instance, wasnt quite what I was looking for.
The fund was formerly known as First Commonwealth Fund and invests almost exclusively in the bonds of Canada, Australia, New Zealand and Great Britain. I'd prefer more exposure to continental Europe. Those economies seem to be lagging recovery the most and therefore are less likely to raise rates.
Another promising closed-end, Templeton Global Income (GIM), fell away when I discovered that its 32% surge last year was partly due to two factors I consider negatives: significant exposure to emerging markets and the disappearance of its traditional discount to net asset value.
Closed-end funds trade like stocks, and often far above or below their net asset value. Last year, this funds NAV rose only 23.6%. But foreign bonds became so popular that investors drove its trading price higher, erasing the price discount. Now that price would have to go to a premium over the NAV for an extra lift, which it has seldom done in its 15-year life.
Last one standing
Ultimately, I was left with Loomis Sayles Global Bond. It's a better performer than T. Rowe Price International Bond (RPIBX), which I mentioned in last weeks column, advancing an average of 9.4% in each of the last five years, compared with the Price funds 4.5% gain.
It's also unhedged. We are running about 70% non-U.S. dollar, says co-manager Ken Buntrock, meaning more than two-thirds of the portfolio is eligible for a currency kick. The portfolio also holds only what he calls a smattering of emerging markets; the average credit quality of the fund is triple-A.
The Loomis Sayles portfolio is perfectly aligned with my own expectations. This year, we think well have two main drivers of return, Buntrock says. No. 1, we think the U.S. dollar still has room to fall, given high federal and current-account deficits, as well as a White House happy to watch it sink in the hope that will spur domestic job growth.
In interest-rate terms, foreign markets are more benign, the manager says. A domestic rate increase is inevitable, even if it's delayed past the fall election, which will push Treasury prices down. Offshore, you are not going to have capital losses, Buntrock opines.
So while domestic intermediate-term government bond funds could be flat this year, with capital losses offsetting their coupons, Buntrock is expecting his portfolio to return 6% to 8%.
Dragged into the mess
Loomis Sayles disclosed last November that it had been contacted both by the SEC and New York's attorney general in their probes of abusive fund practices, including rapid trading.
The company said it had discovered two instances in which institutional investors were allowed to trade Loomis Sayles Bond Fund -- the one managed by Dan Fuss, not Buntrock -- and said both had stopped.
Fuss, a one-time Morningstar Manager of the Year, said at the time the trades weren't disruptive and didnt hurt shareholder interests. I believe him. For one thing, the fund (including institutional share classes) has assets of more than $2 billion and holds more than $60 million in cash. The two traders between them invested only about $35 million.
For another, Fuss and his family are the largest shareholders in the fund, and its hard to imagine Fuss, who was consulted before the investors were allowed into the fund, would punish his personal interest to boost the revenues of his employer. I've argued before that insider ownership is a deterrent to fund fraud.
So while Im annoyed that Loomis Sayles allowed itself to be sucked into the scandal, Im persuaded shareholders weren't hurt. Thats the bottom line, and very different from the experience at other fund companies swept into the scandal. For example, The Wall Street Journal, citing an internal inquiry, reported last week that investors in Massachusetts Financial Services funds were scalped of $100 million.
So my search for a foreign-bond fund has ended. Thats not to say there arent others out there as good or better; just that finding them could give you mouse-click carpal tunnel.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article. He may, however, invest in Loomis Sayles Global Bond Fund, though not sooner than three days after this article appears.
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