Monday Morning: For higher bond yields, set a compass

Stock market returns have been negative for three years now, and the market is showing no sign of a recovery.

At the same time, domestic interest rates are exceptionally low. Ten-year Treasuries are yielding only 3.63%, and five-year Treasuries are yielding an anemic 2.55%.

At such a time, where should the conservative investor look for returns? Non-U.S. bonds, suggest several fund managers.

Non-U.S. bonds at a time like this? Yes for several reasons, as long as the maturities aren’t too long.

First, interest rates are higher in many countries, so you pick up yield. Second, the dollar has fallen against the currencies of many other countries and seems likely to drop further, so you may pick up currency return. Third, you can add capital gains to these returns if you’re successful in issue selection.

Dan Fuss, vice chairman of Loomis Sayles & Co. LP in Boston, and manager of the $1.5-billion Loomis Sayles Bond Fund, notes that Australian government 10-year bonds currently yield 5.15%, New Zealand 10-year government bonds yield about 5.75%, and Canadian bonds yield close to 5%.

In Europe, Swedish 10-year government bonds yield approximately 4.35%, and Norwegian 10-year bonds yield 5.1% to 5.2%.

And you don’t have to go out 10 years to get significantly better yields than 10-year Treasuries, Mr. Fuss says. Because of the different shapes of the yield curves, you often can invest in shorter maturities without giving up too much yield.

For example, while the Norwegian 10-year bond yields 5.2%, you can still get about 4.9% or so for two- or three-year bonds. In New Zealand, the three- or four-year bonds pay about 5.3%, compared with 5.75% for the 10-year bonds.

In the United States, if you invest in two-year bonds, you get only 1.4% to 1.5%.

As a result, Mr. Fuss has about 19% of his fund’s assets in Canadian bonds, and 19% in the bonds of other foreign countries, including New Zealand and Norway. He doesn’t own any Treasuries.

The $90-million Loomis Sayles Global Bond Fund – which was up 24.8% last year – has an even higher weighting in non-U.S. bonds, with assets distributed in the bonds of more than 30 countries. In fact, 62.2% of its assets are in non-dollar bonds.

“There are years where non-dollar bonds have outperformed the domestic market, even though the dollar was flat or strong, because interest rates were higher in other markets,” says David Rolley, portfolio co-manager.

“Interest rates are fairly low around the world today, but you can find higher yields in other markets,” he says. “One reason we think this is a good time to consider a global bond fund as part of your total fixed-income profile is because of the U.S. dollar. I’m a dollar bear.”

Mr. Rolley says the U.S. dollar tends to move in trends. In the `70s, the dollar went in one direction, and that was down, he says. “In the first five years of the Reagan administration, it went only in one direction, and that direction was up,” Mr. Rolley says.

In the later `80s, the dollar was weak, and in the early `90s it didn’t do very much. “Then we had a seven-year-long bull market. It really got going in 1995 and continued until March 2002.”

Now the dollar is weak again.

For a long time if you bought a global bond fund without a currency hedge on it, you were diluting your return, Mr. Rolley says. “It was an out-of-favor asset class. That ended one year ago, and for one year, global bonds have outperformed every other bond category.”

Mr. Rolley and the global fund’s lead manager, Kenneth Buntrock, like the higher yields available in other fixed-income markets, and the likelihood that the currencies, such as the Canadian, Australian and New Zealand dollars, will outperform the U.S. dollar.

Another bond manager who likes non-U.S. bonds is Steve Smith, global bond portfolio manager at Brandywine Asset Management Inc. in Wilmington, Del., whose average account returned 28.8% last year. Mr. Smith has only 20% of his client assets in U.S. bonds, and 80% in non-U.S. bonds.

He says the Iraq situation is having a positive effect on non-U.S. bonds while simultaneously having a negative effect on the dollar.

That’s because recent oil and gas price hikes have taken $320 billion out of the consumer’s pocket and stunted world economic growth.

“That’s deflationary,” Mr. Smith says. “It’s bullish for bonds.”

Especially non-U.S. bonds.

Mike Clowes is editorial director of InvestmentNews and sister publication Pensions & Investments.