One of the reasons that bond investors shun bond funds during periods of rising interest rates is pretty simple. They believe that they are likely to lose money on that investment, in the short term. Why? Because bond prices and interest rates have a classic inverse relationship. That means if your interest rates are headed up, the price value of your bond is headed down. So when you consider that we are now facing a rising interest rate environment in the US, incidentally the largest bond market in the world, you are probably thinking 2 things. First, if rates are rising in the US, then by natural extension, they should be rising everywhere else too. Second, it's redundant to invest in any kind of global bond fund, because most bond funds are benchmarked against an index which obliges them to place most of their holdings in the US. When you add that to the fact that the US dollar is on a clear downward trend, depreciating the value of its assets, be it stocks or bonds, it doesn't take a rocket scientist to tell you that investing in a global bond fund at this point in time, would probably be a bad idea.

However that is only half the story.

Even though rising interest rates are bad for bonds, it isn't entirely a zero sum game. When interest rates pick up, they also cause yields to rise. Which means you can get a higher payout for your bond, and over a period of time, the higher yield can more than make up for the short term decline in the capital value. But more importantly, while US interest rates affect cycles in other parts of the world, there has been a significant decoupling in recent times. Many countries outside of the US are looking to either lower interest rates or keep them at current levels for various reasons. For example, in South Korea, the government wants to lower interest rates to stimulate consumer spending. Also as currencies appreciate against the US dollar, this should give an added boost to their government bonds, making non-US sovereign bonds an attractive option for investors.

That's where absolute return focused global bond funds come in. These are truly global funds, that aren't forced to invest in any particular region because of benchmark considerations. They have the ability to invest in both US and locally denominated debt, thus allowing them to benefit from currency fluctuations. The ability to buy bonds in countries such as the Philippines or the Poland also enables these funds to gain from potentially better yields, or the price appreciation of government bonds due to an improving macro economic environment. The Franklin Templeton Funds - Global Bond Fund (click here for the factsheet) is such a fund. Fund manager Michael Hastenstab says the fund currently has no exposure to US Treasuries, and that's due to his conviction that the US dollar is on a clear downward trend. A specialist in global government bonds, Dr Hastenstab says that he's finding the very good value in regions outside of the US, in places such as Eastern Europe, Scandinavia and Asia. Scandinavia or more broadly Northern Europe is among the fund's firmest bets, because of the region's strong fiscal situation and favourable economic conditions, explains Dr Hastenstab.

More than three-quarters of the fund is in investment grade debt, with an average credit quality of AA-. The average duration for bonds in the portfolio is 3.38 years, and the average yield to maturity is around 4.59% (figures as at end September 2004). The fund assesses risk based on three broad factors: interest rates, currency and yield. In this interview the fund manager goes more deeply into the mechanics of the fund, and explains where and why the fund is finding value outside of the United States.

Bharathi Rajan: We're in an environment where the US dollar is falling and interest rates look set to rise in the US. Neither of these factors are positive developments for bonds. What's your outlook for the US bond market?

Michael Hastenstab: I think from our perspective we're really finding a lot of opportunities outside of the US in terms of fixed income. We are over weight particularly in Europe and in Asia both on the bond side as well as the currency side.

As a fund house we are finding some good opportunities in the corporate bond market (which this fund does not invest in) so we think there are still opportunities for fixed income in the US. They are probably in the sectors that are not in the Treasury market, but in other areas, such as the high yield corporate bonds, which we are overweight for our global total return fund. For this fund we really just focus on government bonds, and we're definitely finding better value in terms of the treasury markets outside of the US where we can benefit from higher yield as well as positions for currencies that we think are undervalued.

BR: So this fund has nothing at all in US government bonds?

MH: Currently now, the global bond fund has 0% in US Treasuries so we are completely out. So for government bonds, the whole fund is in other regions. We broadly break it down to three geographical areas: Americas, Europe and Asia. Europe and Asia form the lion's share of our allocations. We have big positions in Asia ex-Japan, and in Europe. And although we do have a large holding in the Euro area, we have an even larger holding in non-euro government bonds which we think can offer higher yields or potentially have some better currency dynamics. Such positions include countries such as Poland or Sweden, or Hungary, or Norway.

BR: Specifically within Western Europe, where are you positioned?

MH: In Western Europe, it's really Scandinavia, or should I say Northern Europe. That is where some of our larger weightings are. And the reason that we like Scandinavia is the very robust balance of payments situation. Those are the economies that still run trade surpluses and current account surpluses.

Also, we think that their economies are somewhat more flexible and dynamic than the core Eurozone countries. Their ability to generate stronger growth, which will be positive for their currencies, is a bit higher. So that's one of the reasons why we like those regions. In terms of the EMU, it's really a broad diversification for the EMU countries to get the Euro exposure and some of the Eurasian exposures. You know that the deviation in terms of interest rates between the different members of the EMU is quite small so the largest sort of issue there is the overall duration and the currency exposure.

BR: You said earlier that for the Scandinavian countries their ability to generate growth was a positive factor. Could you elaborate on the current condition of these economies? Is the growth specific to areas like telecoms, or is it more general economic growth?

MH: There are a couple of areas of growth. Their labour regulations tend to be a bit more flexible than in core Europe. In terms of growth drivers, Norway's obviously benefited from high oil prices, as a large oil exporter. Sweden is a bit more diversified. Telecommunications has been a strong area for them as well as mineral, pulp and paper and commodities sectors. Machine tool exports have also helped the economy.

BR: How have oil prices affected the Eurozone economies as well as those outside of the EMU? Are some countries more affected than others?

MH: Certainly it's a factor that is affecting the whole globe and there are certain countries that will be able to take advantage of the high oil prices perhaps more directly, and that will be a place like Norway, which is a large oil exporter, or a place like Russia, which is again another large oil exporter. This in turn allows us to feed into the increasing credit worthiness of Russia, or even the strong balance of payments in the current account surpluses in Norway. So we'll be able to find those countries that have a strong correlation or part correlation to oil high prices.

BR: Oil prices have been tapering off. Does that mean when they come back to manageable levels, this advantage would be lost?

MH: No, not necessarily because if you look at a country like Russia, they are benefiting not just from high oil prices, they are also benefiting from very prudent management in running balanced fiscal accounts, paying down debt etc. All of those will still be in place even if oil prices drop to lower levels. Both Russia and Norway also have built up funds to capitalize on the high oil prices and use these proceeds in the future. So the high oil price shock led to large build ups in oil funds for both Russia and Norway. And even if oil prices come off, they will be able to use these funds, because they put them aside for a rainy day.

Now what we have seen happen in Russia, is a very good debt policy. The issuing of new debt is part of the debt management. Overall the debt-GDP ratio has been falling. They have been running some surpluses and they have set up this oil stabilization fund to absorb some of these. So they haven't just spent all the excess money from the high oil prices. They have actually put it away and saved it, so, that to us is a pretty good sign. They have been upgraded to investment grade by Moody's and S&P have put them on a positive outlook, and that's the evidence of what kind of polices the country actually implements. In Russia, it is a case where they really have implemented quite prudent fiscal policies.

BR: You also mentioned that you are finding pretty good ideas in Eastern Europe itself, what are the key drivers there?

MH: Eastern Europe's labour reform languishes behind core Europe, like Germany for example. But it is the flexibility of the labour market and the low cost producer status that Eastern Europe is able to provide, that is drawing in a lot of foreign direct investment. So you have the lower tax rates, you have lower wage costs that are a fraction of they are in Europe, plus you have a fairly highly skilled labor force. They are fairly well educated and the infrastructure is constantly improving, and so that's leading to a lot of FDIs flowing into the region, which is obviously beneficial for their currencies. That is a real competitive factor that is leading to these FDI flows. These are flows that are likely to remain there as opposed to maybe more shorter term portfolio flows that obviously could exit quickly. Those countries that are competitive in terms of their production that we've been focusing on such as Poland for example, have done quite well.

BR: What's the level of risk you take with Eastern European bonds as opposed to say US bonds?

MH: We really look at three elements in terms of risks and return. One is interest rate risk, second would be the currency, and third would be the yield in terms of generating returns. And the first two would really be the risk/return factors. It's a combination of all these three factors and based on the macro-fundamentals that we have thought that allocations to countries outside of the US are more optimal.

In Poland for example, interest rates have been coming off after the market spiked up quite rapidly earlier in 2004. Also the passing of fiscal reforms has helped decrease fiscal risks. These real developments have helped bring in capital and thus led to an appreciation of the currency. So its really weighing in all the macro factors and evaluating it in a total return framework, with interest yield duration and currency considerations thrown in, to see if there's an optimal investment there.

BR: Do you see interest rates coming off in Eastern Europe generally?

MH:Hungary has been cutting rates fairly aggressively, and Slovakia's recently cut interest rates. On the whole, it's somewhat mixed but generally the trend has been that the mid to longer term bond yields across the region have been falling.

I think the common perception is that if the US Fed is raising rates then yields internationally almost go up, but that's really not the case. Korea for example, has been cutting rates, and Hungary has been cutting interest rates. Slovakia has also been cutting interest rates, so it's not uniform. And I think that it's really important that a key advantage of a global fixed income portfolio is that you can go to countries which have more optimal interest rate developments, as opposed to being just focused on one market, like the US.

BR:That's a very interesting point. You have already noted that quite a few countries in Eastern Europe have been gradually easing rates, and the same thing seems to be happening in many parts of Asia. Are you noticing this trend in other parts of the world?

MH: Another case in point would be Australia and New Zealand. They are getting close to the end of their interest rate hike cycle and at least that is what the market is pricing in now on a slightly inverted yield curve. You have fairly different business cycles under way in the US and in Australia and New Zealand. Some interest rate cycles are correlated with the US and some aren't. So that's where we are really focusing our research effort, to look at where each country is in terms of its business cycle as well as interest rates cycle. We then use that information to build our positions as opposed to just taking a broad view that US interest rates are going up so everything else is going up too.

BR: Do you think there is a broad reason for the divergence in the interest rate cycles?

MH: I think you can attribute it to different domestic factors. Australia and New Zealand for example, didn't really go through the type of recession that the US went through. They were actually continuing to grow quite robustly, so they have been raising rates for some time, to try to cool that that fairly strong growth well before the US started to raise rates. Then of course in the Eurozone, you have a different interest rate environment, because you have much slower growth going on in core Europe than you do in the US.

You have an appreciating currency in the euro area, which is putting a dampening effect on the monetary aggregates, so that's functioning somewhat as a rate hike in terms of the effect of the economy. So there's less of a need to raise rates to fight inflation. In cases like this, you can allow the appreciating currency to fight inflation. So I think it is the different variables that are at play. And in Asia, the currency appreciation is serving to tighten monetary policy, so that takes some of the work, or even all of the work away from the interest rate policy. It also depends on the individual country. Some countries like Thailand are doing a combination of both, some currency appreciation, as well as raising interest rates. Korea for example is having the exchange rate do most of the work, and is actually cutting rates.

BR:The consensus is that the US dollar is going to continue to weaken and that undervalued Asian currencies are likely to appreciate significantly against the greenback. In fact, that seems to be the case with other currencies as well, and the US dollar is on a global decline against other currencies. Is this an unusual period in time where at least for currencies, there's seems to be a consensus that most currencies are likely to appreciate against the US dollar?

MH:This is an unusual period in time certainly, as there is a strong consensus that the US dollar is on a downward trend. It's interesting, because not very long ago, the market was talking about a recovery in the value of the dollar. So sentiment tends to oscillate quite a bit. Our approach is really to step away from that shifting sentiment and look at the fundamentals, in the sense that the US is running massive current account deficits plus fiscal deficits, and who is financing all of this? It's the rest of the world (foreign governments buying up US debt)

Yes, this is a unique situation which is why we underweight the dollar and overweight other currencies. Now will the market go from bearish on the dollar as it is right now, to bullish before the end of the cycle? It's quite possible. We've gone through the whole dollar cycle. We have been underweight the dollar for quite a couple of years. But there have been quite a few periods when the market has gone from one side to the other in terms of sentiment. So I think it's quite natural we tend to view those oscillations in sentiment more as an opportunity to add to those positions that we still like, even if the market becomes negative. Just as long as the fundamentals still remain intact.

It's also a unique situation in the sense that the conditions for the US dollar are pretty bad in terms of fundamentals. But we should remember that this happened on quite a few occasions in many countries, where currencies have weakened to compensate for a current account or trade imbalance. This has happened across history and across countries. It's a natural development and not something that is necessarily a serious negative. In fact it can be a stabilizing factor and can be quite good for the US in terms of promoting growth. We think the current situation in the US is unique in the sense that the magnitude of financing is sort of extreme but this type of events have happened throughout history, and with fairly predictable results in the long term.

BR: To what extent will a significant depreciation in the US dollar actually help the US finance its deficit?

MH: Well, it will just make imports more expensive and therefore should begin to decrease the magnitude of the trade deficit. Therefore the US won't require as much funding.

BR:Let's talk about some of the positions in the fund. As at the end of September 2004, Australia accounts for about 5.83% of the country allocation. The economy has done well and the AUD appreciated significantly in the past couple of years. Is it overvalued yet? And are you thinking of paring down this position?

MH: No, we're still comfortable in our holdings in Australia dollars. Reason for that is rates in Australia is still quite high relative to other developed countries. The second reason is that Australia is still benefiting from an improvement in terms of trade, despite its appreciation of the currency. The demand for their exports is still quite strong especially in the commodities sector. You also see the potential for Australia to benefit from the increased immigration flows into Australia, especially from Asia and the US. And Australia is running a balanced fiscal account, so there are some positive macro economic factors that would support Australian dollar values, especially in conjunction with the fact that the US dollar will continue to weaken.

BR:What are some of the positions that you have in Latin America for the portfolio?

MH: In the Americas, we have a significant weighting in Canada. In Latin America, we have much smaller and selective allocations such as Venezuela, Brazil, Columbia, and Mexico.

BR:Why are the allocations smaller?

MH: In the past we had larger allocations in emerging markets such as Latin America. These positions have done very well over the last couple of years and we just have been using the opportunity to take profits there, and allocate those funds to some of the local currencies opportunities in Asia and Europe. So it is really just finding some better opportunity elsewhere, but we are still comfortable with the fundamentals in that region.

BR: Am I right to assume that all the positions in the fund are all in local currency and not in US dollar denominated debt?

MH: Not really. Some of the positions for example in Ukraine and Russia are in US dollar denominated holdings. In Mexico the positions are a combination of Euros and US dollars, and in Venezuela it's in US dollar debt. So basically in Latin America it's all external debt, whereas in Asia excluding Philippines, it's all in local currencies. This includes positions in Indonesia, Korea, and Thailand etc. In Philippines it's in external debt, in US dollars and Euros.

BR: What is the reason for holding US debt in Latin America? Is that a reflection of your views on the Latin American currencies?

MH: No it is less a view on the Latin American currency and more a view on credit spreads. So you're earning a significantly higher yield than US Treasuries would offer. We think that the fundamentals there in terms of debt repayment capacity are good, so we are able to earn a higher yield and benefit from declining risk premiums and take less of a currency exposure in Latin America. It's more of a sovereign debt payment capacity payment we're looking at than a currency issue in this case.

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