Which one you choose depends on your outlook for the U.S. dollar. By Jennifer Schonberger, Staff Writer September 23, 2010 Investing in overseas bonds offers the potential for solid returns and helps diversify your portfolio by giving you exposure not just to foreign debt but to other nations’ currencies as well. Pimco, the highly regarded fixed-income specialist, offers two foreign-bond funds: Foreign Bond (US Dollar-Hedged) D (symbol PFODX) and Foreign Bond (Unhedged) D (PFBDX). The funds have performed exceptionally well this year. As of September 22, the hedged fund returned 10.2%, while the unhedged version returned 11.4%. That compares with a return of 7.0% for the average global-bond fund, according to Morningstar. The Pimco funds are in the top 18% and 7% of their category, respectively, so far this year. Both funds invest mainly in high-quality foreign-government bonds issued by developed countries. The funds are virtually the same, except that the hedged version is less affected by changes in the value of foreign currencies relative to the U.S. dollar. That tends to make the hedged fund’s share price more stable than that of the unhedged fund, which is not protected from currency fluctuations. Generally, the more-volatile unhedged fund will do better when the dollar is weak and worse when the dollar is strong. Because the dollar has generally fallen in value over the past five years, the unhedged fund has a better record over that period than the hedged fund -- 7.6% annualized versus 6.2% annualized. With growth tepid around the developed world, investors have rushed into high-yielding government bonds issued by almost every developing nation with a pulse. That’s pushed up prices of the bonds of those nations while pushing yields down (bond prices and yields move in opposite directions). Advertisement Scott Mather, manager of both funds, has stuck to investing in high-quality bonds with longer maturities in countries with relatively strong economies. He is betting that in this economic environment, bonds from strong, developed countries will do well. That’s because slow growth in those countries should mean low inflation, which in turn should keep interest rates down and maybe even send them lower. And lower rates would mean rising bond prices. Based on his strategy, Mather has been favoring bonds from such countries as Germany, England, Canada and Australia, while he has been avoiding bonds from shakier nations, such as Greece, Ireland, Spain and Portugal. Mather seems unfazed by those who see a bubble in bonds and expect prices to deflate as interest rates rise. With inflation under control and the prospects of deflation on the horizon, Mather says, yields on government bonds remain reasonable. The average duration (a measure of interest-rate sensitivity) of both funds is about 6.5 years. That suggests that each fund would lose about 6.5% of its value if interest rates rose by one percentage point (and gain 6.5% if rates fell by one point). If foreign bonds are still attractive, the question becomes which of the two Pimco funds to buy. That requires making a judgment about the future of the U.S. dollar. You’d think that with all of our economic problems, the dollar’s trend for the foreseeable future would be down (see Make a Buck Off a Sagging Dollar). But the dollar has seen periods of strength this year, too, because investors see it as a safe haven in times of turmoil and uncertainty (see Stronger Dollar Here to Stay). Moreover, other countries -- most notably China -- continue to intervene in foreign-currency markets to keep the U.S. dollar higher (and their own currencies weaker, helping their exports). Japan has recently begun to intervene in its currency markets to push the yen lower against the dollar. Advertisement However, the dollar could sag if the Federal Reserve decides to flood the economy with more money to combat a slowing recovery. But because of the hedged fund’s greater stability, as well as the dollar’s occasional signs of strength during all-too-frequent periods of market panic, we think the hedged fund is a better choice for the time being.