Wild and Woolly World of International Bond Funds

By Markets Bankrate.com

Many investors have poured money into bonds, especially U.S. bond funds. To have a truly diversified portfolio, however, you may want to put a slice of your portfolio into international bonds. Although bonds can be ridiculously confusing, here's a closer look at the benefits and risks of investing in international bonds.

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How to Get Started

If you buy individual bonds and especially foreign bonds, "You're entering a dark and wizardly world," says Russell Wild, financial planner and author of "Bond Investing for Dummies, 2nd Edition," who adds that these bonds can come back to bite investors. "For most people, buying (exchange-traded funds) or mutual funds will make a lot more sense."

Because of ever-changing exchange rates and unknown risks of default, international bonds can be both dangerous and confusing. Sticking with mutual funds or ETFs that give you instant exposure to baskets of bonds is a safer, and often easier, option.

What is the downside of funds? You pay fund fees, and these can vary greatly. "Do you want to pay 1.5% to a bond fund manager when your expected return is 1.5%?" Wild asks. "Do the math. You want low fees on any fund you own."

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Wild is a proponent of ETFs or index mutual funds, primarily because these are often the least expensive choices.

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Risks and Benefits of International Bonds

James Picerno, author of "Dynamic Asset Allocation" and owner of finance blog The Capital Spectator, says that diversification is the main benefit of international bonds. "You want to have as broad as exposure as possible when building your portfolio. Bonds march to their own drummer when compared to stocks and domestic bonds," he says.

"When designing a portfolio, you don't want securities tied to the same boom-and-bust cycle. Combining the two asset classes (international and domestic bonds) makes them less risky without eating into your return," Picerno says.

Many people are drawn to international bonds because of the high yield. The yield tells you how much money you may receive if you buy the ETF or fund. But be forewarned: Yield is a difficult concept to understand.

"High yield usually means high danger," Wild says. "In the world of bonds, it's not the yield that matters, but return. The biggest misconception is that yield is going to be your return, but it's totally different."

You must look at return in retrospect. "You do not know what the real return is going to be on a bond that you hold for a year, let alone longer, especially on the international side," Wild says. "You see that a bond is paying 5%, but when you cash out, the exchange rate is going to be different, and that will affect your total return."

The exchange rate is a key factor.

"If the dollar goes up for a few years, international bonds will not do as well," Wild says. "If the dollar goes down for a few years, international bonds will do better."

Another misconception is people think what happened in the past will continue into the future. "Past returns, as it says on the bottom of every prospectus, are not indicative of future returns," Wild says. "Because of falling interest rates, the last 20 years have been the golden era of bonds. But interest rates can't keep falling forever."

"Will interest rates go up? Yes," Picerno says. "But who knows when? People have been making that argument for 20 years, but eventually, they will be right. The real warning sign is if the economy starts to strengthen and return to more normal levels of growth. That would be a good sign. If the (Federal Reserve) is raising interest rates, they're no longer worried the economy is too weak. It would be problematic for bonds, but we're nowhere near that now."

Currently, investors are pouring money into short-term bonds. But inflation is a huge danger. "With inflation running at 2%, many short-term bonds are paying only 1.5% or less," says Wild. "Some people are losing money" in terms of purchasing power.

Wild cautions that if inflation takes off, you could see a greater loss of value in your portfolio.

Interest rates are another danger. "The Fed will do everything in its power to keep interest rates low, at least while unemployment remains high," says Wild.

But over time, low interest rates hurt retirees and anyone on a fixed income. "Eventually, the governments of the world will loosen up and allow interest rates to rise. At that point, bondholders are going to get hurt."

Can the government control inflation and interest rates so bond buyers aren't hurt too badly?

"Not perfectly," Wild says. "At times, either can get out of control. It's a very complicated web over which governments have limited but far from absolute control."

Don't Forget to Rebalance

Picerno suggests that most investors "probably want to own only one or two foreign bond funds, and at least one of them should be broadly diversified against countries, currencies and regions. Think holistically, and periodically rebalance your portfolio."

Wild also believes in the power of rebalancing: "Shave off an asset class that is doing well for one that is doing poorly. Study after study says that rebalancing is the way to get the highest long-term return for the lowest amount of risk."

Copyright 2012, Bankrate Inc.