International bond fund net inflows have exploded in the past years as millions of investors made the proverbial flight to safety from the imploding dollar. But as interest in international bonds expands, even the biggest fund manufacturers don’t have enough products to meet the growing demand from advisers. In this article, we post an update on the marketplace and discuss the attractive opportunities in International Bond products.

• Category overview
• Top fund manufacturers and funds
• Competition from ETF/ETN
• To hedge or not to hedge
• The future for international bond products

Category Overview

International bond funds invest 40% or more of their assets in foreign bonds and hold primarily investment-grade bonds of politically stable, developed countries. They differ from emerging-markets bond funds which have 65% of their assets in emerging market debt. The most successful manufacturers in the category are Oppenheimer. FranklinTempleton. and American Funds as ranked by asset size and growth. In terms of category positioning, the top 3 manufacturers carry one large, focal fund, while firms such as PIMCO and Dimensional have two funds, inherently with different characteristics (hedged, un-hedged and different maturities)

Throughout the years, international debt has been known to add stability to investor portfolios. The correlation between the investment-grade Lehman Brothers Global Aggregate index and the Lehman Brothers Aggregate index has fallen to 26% for the quarter ending June 31, 2007. In comparison, the 10-year and 5-year period correlation is 69% and 70%, respectively. However, international bonds are not risk-free and bear markets such as 2000-2002 affected the category profoundly, with funds bleeding a total of $4B in net outflows. In terms of product development, the last two years saw the introduction of a small number of ETF/ETN products; however areas such as global high-yield debt (world junk bonds) or foreign single-country debt are still not claimed by manufacturers.

Top Fund Manifacturers and Funds

The $6.2B Oppenheimer International Bond, unhedged [OIBAX] is the undisputed best-performer in the category, with a 5-year return of 14.18%. Arthur Steinmetz, manager of the fund has outperformed its benchmark for 6 out of the last 6 years. When Russia defaulted on its debt in 1998 and emerging-market bonds tumbled, the fund had one and only losing year since it opened in 1995.Over 1-, 3-year, and 5- year periods it finished in the top 5% of funds in this category. Steinmetz currently favors the golden age of Brazil and has 6.7% of un-hedged assets in the country, in addition to 54% of its assets in developed countries The fund has Morningstar’s highest rating of five stars, and Sharpe ratio of 0.63, compared with 0.03 for other international funds. A higher Sharpe ratio indicates better risk-adjusted returns. Other performers in the top 10% of this category are $6.5 billion Templeton Global Bond hedged [TPINX], $1.5 billion Alliance Bernstein Global Bond Fund -22% leveraged, un-hedged [ANAGX] with 12.74%, 10.45 % respectively for the 5-year period.

Another notable fund, on track to post a great performance is the $2.6 billion T. Rowe Price International Bond [RPIBX]. The fund has had average annual returns of 8.3% over the last 5 years; and this year alone has returned remarkable 9.13 %. It has no exposure to the dollar, hedges one foreign currency against another, yields 3.8 %, and charges 0.84% in annual expenses.

Competition From ETF/ETNs

Competition until now revolved around international and emerging bond mutual and closed-end funds. However, FRC expect to see significant evolutionary innovation in product development resulting in more ETF/ETN products. ETFs offer a less volatile way to access foreign bonds than the traditional closed-end fund, since they have fixed number of shares and lesser NAV- to- market price fluctuations. State Street recently launched a global TIPS product — SPDR Lehman International Treasury Bond ETF (BWX ) coincidentally at the same time as PowerShares was vying to list an emerging market bond ETF. The PowerShares Emerging Markets Sovereign Debt Portfolio (PCY ) is the first of its kind and it is the first ETF to focus exclusively on emerging market sovereign debt. Its expense ratio is the highest of PowerShares’ fixed income ETFs at 0.50%, but similar to State Street’s SPDR Lehman International Treasury Bond ETF (BWX ). While the State Street’s global TIPS ETF strikes us as a worthwhile product, it does not work as a core, stand-alone foreign bond product, since it excludes a large number of developed countries.

To Hedge or Not To Hedge

Returns from international bond fund come not only from the bonds themselves but also from currency fluctuations. Part of the reason investors choose to buy international bonds is to add exposure to currencies other than the U.S. dollar to their portfolios. PIMCO. an interesting case in this hedging debate, saw opportunities in both — hedged and unhedged foreign bond funds. PIMCO’s Foreign Bond Dollar Hedged [PAIIX] fund and the PIMCO Foreign Bond -Dollar Unhedged [PFUIX] fund have similar holdings but the two portfolios are not exact clones. The unhedged fund started trading in April 2004, four years after its hedged cousin was introduced. Both funds yield more than 2.5% and have expense ratios of below 1%. This year through Thursday, the unhedged foreign bond fund returned 6.6% while the hedged foreign bond fund returned 1.5%. Unsurprisingly, its un-hedged version is outselling its hedged sibling at a rate of above 2-to-1.

Foreign exchange moves are at the crux of the argument over whether to invest in an international bond portfolio that hedges its exposure to foreign currencies. Because foreign exchange rates are so volatile, rate swings tend to overwhelm the benefit of fixed-income diversification. So deciding between a hedged and an un-hedged fund is important. Advisers have to understand their clients’ risk tolerance before deciding between hedged and unhedged funds.

The Future For International Bond Products

In the short run. international bond funds and ETFs have a great place in the allocation process as a method of diversifying risk. With yields on Treasury bonds still hovering below 4.5%, the high yields offered by foreign debt issuers seem extremely appealing. However, given the global mastery required for top performance in this category, the precise selection of portfolio manager or sub-adviser could make or break a product’s potential. For advisors, investment strategists recommend holding international bonds in tax-deferred accounts, because taxes on the bonds’ interest are usually higher than taxes on dividends from stocks.

Whether new international bond funds and instruments proliferate in the long-run, may ultimately depend on the future of the dollar. There is an inverse correlation between dollar weakness and interest in international bonds; however that alone will not be the sole determining factor. Expect ETF/ETNs to establish a viable alternative and heat up the competition for existing funds. Jack Brennan, CEO of the Vanguard Group recently quipped:

For international bond ETF’s, we don’t today offer international bond funds, so I don’t see that yet. There is a good healthy debate in Vanguard on how international bonds can or should be used for American portfolios.

Unmistakably, the big providers-Barclays, Vanguard and State Street are lagging the opportunity here, however given the burgeoning net inflows, expect to see a sizable awakening, a sort of renaissance in product development for ETF, index, as well as additional active products in the category.