With Dollar Weak, Foreign Debt Could Be A Smart Bet

With domestic interest rates hovering around zero, is it time for debt investors to look beyond U.S. borders?

Issues of foreign bonds are at their highest levels since they were first tracked almost 50 years ago, thanks to the higher yields found in such emerging markets as China, Brazil and Russia. In the first half of this year, bond volumes rose to $352 billion, according to Thomson Reuters, an increase of 45% from the same period in 2007 - which was before the global financial crisis took hold in the world’s capital markets.

“Although emerging market bond spreads have narrowed, they still offer a lot of value compared with developed market corporate spreads, with better credit fundamentals in many cases,” Bryan Pascoe, global head of debt syndicate at HSBC Holdings PLC (HBC), told The Financial Times.

A “bond spread” refers to the difference between the yields of bonds with differing credit ratings. In this case, emerging-market bonds with a perceived higher degree of risk are being compared to their less-risky developed market counterparts.

A $1 trillion injection into the International Monetary Fund (IMF) by Group of 20 (G-20) leaders in April made foreign bond investing less risky, says one emerging market strategist.

“From an investor’s point of view, it does make sense to buy emerging market bonds because there is a safety net,” BNP Paribas’ (BNPQY.PK) Shahin Vallee told The FT. “Since the G-20 committed extra money to the International Monetary Fund in April, it has become clear that the governments will not let an emerging market country default.”

Money Morning Contributing Editor Martin Hutchinson doesn’t buy the “safety net” idea.

“Some of these countries are badly run and the safety net would just give them more time to waste resources, like Argentina in 2001,” Hutchinson said, citing eastern European nations such as Hungary and the Ukraine. While other nations like Brazil, Chile and Poland are well run, Hutchinson said, foreign debt is “probably still not a buy at the top of a mini-bull market as we have currently.”

Still, if the U.S. Federal Reserve’s “exit strategy” fails to keep inflation in check, some will bet against the dollar with foreign bonds. Ihab Salib, who manages Federated Investors Inc.’s (FII) $100 million Federated International Bond fund, is one such bettor.

“If you only invest in the U.S. you get 25% of what’s out there,” he told Fortune magazine. “If you’re looking for balanced, diversified exposure, it’s not prudent to ignore 75% of the world.”

The bull market for foreign bonds is just beginning and getting in now will put investors ahead when inflation and a depreciating dollar really begin to bite, Salib said. Even if Fed Chairman Ben S. Bernanke’s exit strategy works and future increases in U.S. interest rates keep inflation down, owning a few foreign bonds could provide a diverse portfolio and, in many cases, pay higher yields than what could be earned in the United States.

Salib’s fund currently yields 4.3%, versus 2.4% for the Vanguard Intermediate Term Treasury fund (VFITX).

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