Foreign Bonds Provide Buffer If Dollar Declines

American investors can buy bonds issued by foreign governments that are designed to provide protection against inflation, but strategists say those bonds are really more of a bet against the dollar.

“If you are a U.S. dollar-based investor, the currency fluctuations will overwhelm anything you get from inflation indexing” on the foreign bonds, said Aaron Gurwitz, the head of global investment strategy at Barclays Wealth.

For more than a decade, the United States Treasury has been selling bonds protected from inflation, known as Treasury Inflation-Protected Securities, or TIPS, whose coupon payments are based on changes in the Consumer Price Index. Investors primarily concerned about protecting their purchasing power during retirement should own TIPS, Mr. Gurwitz said.

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Some strategists say that owning the foreign bonds — individually in a well-rounded bond portfolio, or through an exchange-traded fund — can be a good way to diversify and add exposure to other currencies.

Brett Hammond, the chief investment strategist at TIAA-CREF, pointed out that global inflation-protected securities, as these bonds are called, typically perform very differently from other asset classes like stocks and commodities — and even other types of bonds.

Owning any type of foreign bonds hedges an individual investor’s portfolio against a decline in the dollar and is especially useful if the portfolio has little exposure to other currencies through investments like foreign stocks. This is true, he said, for investors of any age.

David Darst, the chief investment strategist for the global wealth management group of Morgan Stanley Smith Barney, recommends global inflation-protected securities precisely because they are both a hedge against a decline in the dollar and protection against global inflation.

“It is more of a currency play than an inflation play,” he said. “But to the degree that inflation picks up with a global economic recovery, then you will be getting two hedges.” Morgan Stanley projects the dollar will fall to $1.60 against the euro by the end of 2010, down from about $1.50 now.

Mr. Darst recommends that individual investors hold 3 percent to 4 percent of their total portfolio in inflation-protected bonds. This allocation could be entirely in TIPS or in a combination of TIPS and global inflation-protected securities, he said, depending on what the investor thought of the dollar.

American investors can buy bonds from specific foreign countries through a broker, or investors can own a diverse basket of the bonds by purchasing the SPDR Deutsche Bank International Government Inflation-Protected Bond exchange-traded fund. This fund owns inflation-adjusted bonds from 17 countries, including France, Brazil and South Korea, but not the United States. The bonds are denominated in 14 currencies. At the moment, no comparable traditional mutual fund is available, according to Morningstar.

Scott Burns, the director of exchange-traded fund analysis for Morningstar, recommends owning both the Deutsche Bank fund and the iShares Barclays TIPS Bond Fund, which only owns American TIPS.

He pointed out that a decline in the dollar often coincides with rising inflation. “If the dollar goes down, the Consumer Price Index generally goes up,” he said, because the cost of imported goods increases for American consumers.

For investors who want exposure to foreign currencies but are not interested in inflation-protected bonds, Mr. Burns recommended two funds that own traditional foreign government bonds: the SPDR Barclays Capital International Treasury Bonds fund, which primarily owns bonds issued by developed countries, and the iShares JPMorgan USD Emerging Markets Bond fund. Because inflation has been very low during the recession, many investors have not been focused on inflation-adjusted bonds, which makes it easy to gauge the broad market consensus for inflation: the difference between the interest rates offered for TIPS and for plain Treasury bonds indicates what investors think future inflation will be. At the moment, TIPS prices suggest an average annual inflation rate of 1.6 percent over the next five years and 2.11 percent over the next 10 years.

If inflation is higher than that over 5 to 10 years, the current TIPS bondholders would get a higher return. If inflation fears return, though, those expectations will probably be priced into the TIPS market.

Some investment strategists say that makes this a good time to buy inflation-protected bonds — either TIPS or their foreign counterparts — precisely because the outlook for inflation is relatively benign. “You don’t want to buy flood insurance when the river is already in your living room,” Mr. Burns said.