For AAA-rated safety, think globally
Bonds from several countries that haven't been downgraded and still boast top credit scores also pay higher yields than US Treasurys.
In spite of the Standard & Poor's downgrade, investors have flocked to Treasurys in recent days, pushing yields close to zero. Meanwhile, 16 other countries have retained their pristine credit rating, still pay respectable yields and may be better bets.
International bonds have gained currency in recent years, as investors look to take advantage of better yields overseas. While many countries are a dodgy bet (sorry, Italy), others aren't: Canada, Sweden, Switzerland and the United Kingdom are all rated triple-A by S&P and have been paying higher yields than the U.S. The yield on a 10-year Australian bond, for example, was 4.5%, and both U.K. and Canadian bonds for the same duration paid more than 2.6%.
For investors who have added plenty of international stocks to their portfolio to take advantage of growing economies abroad and to diversify their holdings, bonds issued by foreign governments make sense for the same reasons, says Ronald Deutsch, managing director of Sage Capital Management, who has increased international bond holdings for his clients by 2 percentage points to 7% in recent months.
Advisers also like these international bonds because they provide some diversification against the dollar, says Jack Malvey, chief global markets strategist at BNY Mellon Asset Management. Because foreign bonds are denominated in local currency -- an Australian bond is issued in Australian dollars, for example -- if that currency gets stronger against the dollar, the bond will be worth more, in dollar terms. Given that many advisers expect the dollar to slide lower, international bonds may offer even bigger returns than the yields would suggest, says Ward Brown, a fixed income portfolio manager at MFS Investment Management.
International bonds still have risks. Like all bonds, these highly rated sovereign bonds could be negatively impacted by rising interest rates and actual or anticipated inflation. But there's the added risk of currency fluctuations; any drop in the currency value can lead to significant losses for bondholders, says Chat Reynders, CEO of Reynders, McVeigh Capital Management in Boston.
McVeigh owns Canadian and Australian bonds but plans to wait on buying more because of fears that falling commodities prices will weaken their currencies.
As with any domestic bond, there are two ways to buy bonds issued by foreign governments: one at a time, or as part of a bond fund. Many brokerages sell international bonds -- primarily through the secondary market but investors can also purchase bonds directly from foreign governments through their broker. (There is no equivalent of Treasurydirect.gov, where U.S. investors can purchase Treasurys via an auction) If investors buy individual bonds, Reynders recommends they create what's called a ladder, with bonds of different durations, and keep the duration short (typically less than five years), which can help protect investors if the dollar rises against the foreign currency.
Investors who don't want the hassle can get some of the same benefits from exchange-traded funds or mutual funds, says Brown of MFS Investment Management.
Jeff Tjornehoj, a senior research analyst at Lipper, recommends the Pimco Foreign Bond (PFUAV), which holds high-quality debt from developed nations. The fund has returned 11.43% annually over the past three years, compared to 7.6% for the average international bond fund, according to Lipper. It charges .50%, or $50 for every $10,000 invested. Another option, says Deutsch: Templeton Global Bond Fund (TPINX), which invests primary in bonds of governments and government agencies and has posted a 3-year annual return of 13.47%; it charges .91%, or $91 for every $10,000 invested.
Related at SmartMoney.com: