While bond funds have outdistanced their stock counterparts throughout the three-year bear market, the best performers right now are international bond funds.
So far this year, the world bond category has outpaced all other bond funds, with a positive return of 4.04 percent, according to fund tracker Lipper Inc. That's nearly double the performance of general domestic bond funds, which have a year-to-date return of 2.32 percent.
And that's well above short- and intermediate-term investment-grade bond funds, which have a positive return of 1.5 percent so far in 2003, and short- and intermediate-term U.S. government and Treasury funds, with a positive return of 1.3 percent.
The biggest reason for such healthy returns by international bond funds -- those made up of debt from foreign governments and companies overseas -- is the weak dollar. When the dollar declines, the price of securities that are denominated in other currencies, such as a British bond fund that is priced by pounds sterling, goes up.
But international bond funds are not suited for most individual investors, said Don Cassidy, senior research analyst at Lipper.
Investors who buy world bond funds have really added new "sources of uncertainty that they have to think about in their investing," Cassidy said. "The biggest one is: What will the dollar do? And the second one is: How will events overseas unfold?"
"I would be especially careful to have a small allocation, because my prediction is that [many investors] would neglect to watch," Cassidy said. "And things change, for better or for worse."
Bonds and bond funds are considered safer because they are essentially IOUs from companies, governments or municipalities, whereas the fortunes of stocks depend on corporate earnings.
Investors purchase bonds or bond funds with the idea that they will recoup their investment along with interest by the specified maturity date.
One thing that bond fund investors have to be aware of is interest rates.
Analysts say international funds are also doing well because prospects for interest rate cuts overseas are greater than in the United States. The Federal Reserve has reduced rates 12 times since early 2001 to reinvigorate the economy. The federal funds rate, the interest that banks charge one another on overnight loans, now stands at 1.25 percent, the lowest since 1.17 percent in July 1961.
While some economists and analysts believe the Fed will lower rates by another 0.25 percentage points when it meets next week, rates simply can't come down much more.
Bonds become more attractive when interest rates decline because low rates mean other conservative investments, such as savings accounts and CDs, pay less.
"Many investors feel great potential for declining interest rates overseas, and that with the declining U.S. dollar there is more chance to increase their yield," said Thomas F. Lydon Jr., president of Global Trends Investments, a money-management firm in Newport Beach, Calif.
While stocks abroad have been pummeled, the yield on corporate debt is higher overseas, where there have been fewer corporate accounting scandals.
"Think about Germany, for example. Their domestic stock market has been crunched, but they have great investment-grade corporate bonds where you can get 6 percent, whereas a corporate bond here for a company like IBM might be paying 3 percent," Lydon said.
Investors need to closely monitor the performance of these funds. They need to keep in mind that international bond funds will essentially run counter to the rest of their portfolio, which is denominated in dollars. As the dollar declines, investors in international funds will pick up more shares. But when the dollar starts rising, the returns on such funds will certainly be less robust and could be a drag on the overall portfolio.
Based on the size of the different categories of bond funds, individual investors indeed feel less certain about investing abroad. World funds are the smallest classification of bond funds, with assets of $700 million, according to Lipper. Meanwhile, high-yield funds, also called "junk bonds," have $91 billion in assets, corporate debt funds have $86 billion, and U.S. Treasury money-market funds have $71 billion in assets.