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Dollar's Bounce Baffles World Bond Funds

Dollar bears seem to have their nose stuck in the honey pot.

World bond funds are the place to be for investors betting against the greenback. Particularly popular are the world bond funds that don't hedge currency exposure. These offerings benefit not only from the steady yield supplied by foreign bonds but also from any currency appreciation against the dollar.

In 2004, investors in unhedged world bond funds saw their dollar pessimism pay off. The dollar slid by 9% against the euro last year and slightly under 4% vs. the yen. That gave investors in these funds spectacular low-double-digit returns -- and accelerated already strong inflows into the sector.

But 2005 has told a different story. Worries over Washington's so-called twin deficits -- the yawning U.S. budget and trade gap -- continue to mount. Yet the dollar has turned the corner, rising 4% against both the yen and the euro.

The dollar's surprising strength has caused world bond funds, both hedged and unhedged, to become Morningstar's worst-performing fixed-income category. The average fund has lost 1.9% this year.

So what's next for the dollar bears and their favorite bond-fund toy?
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