If the slide in interest rates still has you wondering where t go for higher yields, and you find "junk bond" funds unsuitable, you may want to take a look at world income funds.
Such funds, which invest solely or primarily in higher-yielding foreign government bonds, involve the same risks that domestic bond funds do. There's a credit risk: the risk that issuers of the bonds won't pay interest or principal on time. And there's a market risk: the risk that the bonds' prices will fall when interest rates rise.
They also involve currency risk: the risk that the foreign bonds' principal and interest payments will bring in fewer U.S. dollars if the currencies on which they're based gain strength against the greenback.
Many investors have accepted these risks and have been rewarded, judging by the Salomon Brothers World Government Bond Index (see table). In fact, the government securities of other major industrial countries provided higher total returns in U.S. dollar terms (interest plus or minus price changes) than U.S. government bonds in eight of the last 10 years. (The exceptions: 1981 and 1984.)
Foreign bonds served U.S. investors well when the U.S. dollar was weak. But when the dollar was strong, they had disappointing results despite high foreign yields.
For most individual investors, mutual funds are the only way to play this game. Selecting, buying, owning and selling bonds issued in countries around the world require skills, resources and market access that individuals just don't have.
In studying world income funds, you'll find a lack of past performance data. Only one fund, Massachusetts Financial Worldwide Governments Trust, which started in 1981, has a long track record. (Its average annual total return for the 10 years through March 31 was 13.3 percent.) Competitors didn't arise until 1986.
Under the circumstances, you'll have to rely more on yearly total returns than you may be accustomed to. This may not be cause for regret. As the accompanying table indicates, the returns of funds in this group can fluctuate significantly, and it's better that you are forewarned of such volatility before investing.
Focus on four criteria:
1. Investment objective -- about half of the funds in the group state they aim at high income first and capital appreciation second. The other half aim at high total return. If you're reinvesting dividends, it may not matter much. But if you want to take your dividends and look for a fund shooting for high income, check its total return record to affirm that it doesn't jeopardize principal in pursuit of yields.
2. U.S. vs. non-U.S. holdings -- Some funds, such as Kemper's, T. Rowe Price's and Scudder's, invest in few, if any, U.S. securities. Those funds tend to excel when the U.S. dollar falls against other currencies, but they can suffer when the dollar is gaining. Managers of those funds try to mitigate that risk through practices such as currency hedging and loading up on Canadian and other bonds that move more in line with U.S. securities. It might be a good idea for you to diversify by also investing in a U.S. bond fund.
OC Managers look for markets in which real interest rates are high
and inflation rates are subsiding, leading to the hope of lower nominal interest rates and capital gains.
3. Credit risk -- Some funds buy only government bonds, while others also buy corporates -- usually investment-grade -- to enhance yields.
4. Market risk -- The bond markets represented in the Salomon index had a weighted average maturity of 7.8 years on April 30. Some fundsare lower; others, higher. With interest rates still falling in the United States and starting to fall elsewhere, managers are locking in higher yields and lengthening their maturities. Mark Turner, manager of the Scudder Fund, began last August to lengthen its maturity from 5.6 years to 9.0 years, contributing significantly to its 12-month performance.