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?

Dollar Doldrums

The dollar's recent bounce may have shaken the dollar bears, but it hasn't collapsed their case.

Just last week, the U.S. trade deficit, aggravated by surging imports of oil and textiles, soared to an all-time high of $61.04 billion in February. And while the budget deficit narrowed in March, the Treasury still reported a $71.23 billion budget gap last month. The cumulative deficit for fiscal-year 2005 was $294.65 billion, down from a cumulative $301.40 billion in the first six months of fiscal 2004 ended Sept. 30.

If the U.S. doesn't work to reverse these shortfalls, the dollar bears say it could lead to a crisis of confidence among the international lenders currently buying U.S. Treasury notes. The Japanese and Chinese governments, for example, hold a combined $900 billion in U.S. Treasuries, and even the slightest hint of their plans to diversify away from the dollar would cause major volatility in the bond and equity markets.

"The current account problems we saw last week are proof there are ongoing trade issues, so it's a reasonable idea that the dollar could go down," says Ian Kelson, portfolio manager for the unhedged $1.8 billion

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T. Rowe Price International Bond fund. "But on the other side, there is interest rate support for U.S. securities because growth in Europe and Japan is still slow."

Kelson adds that there is even a pervasive argument that rates should be cut in Europe to spur growth, though he believes euroland will simply opt to maintain current levels until growth is less patchy.

Arthur Steinmetz, portfolio manager for the $2.6 billion unhedged

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Oppenheimer International Bond fund, says the dollar has reached the point of being undervalued against the euro, but Asian currencies still look attractive.

"An end to zero rates in Japan and the end of the Chinese currency pegs are events that loom in the future that will provide the next leg of dollar weakness against Asian currencies," he says.

Picking the Best World Bond Fund

Investors in Steinmetz and Kelson's funds should benefit if the dollar falls, because of the funds' wide foreign currency exposure. Nevertheless, both fund managers advise investors looking to add international bond funds to their portfolios to do so for diversification and yield purposes, rather than as a currency play.

No matter what their reasons for buying, Morningstar analyst Lynn Russell advises investors "read the box to know what the ingredients are" when selecting an international bond fund. That means knowing how -- and where -- the fund allocates its assets.

In the case of Kelson's fund, the T. Rowe manager prefers to stick to highly rated, sovereign debt from developed countries such as Germany, Japan and Italy.

"Euroland bonds are still attractive," says Kelson. "The yield curve is steep, rates are seemingly on hold, and inflation should come down when energy costs stabilize."

High unemployment in countries like Germany and France also prevents wage pressure from stirring inflationary forces, says Kelson, and that in turn provides a good environment for bondholders. He does not expect euroland economies to further deteriorate into credit risks, however, as he sees economic progress taking place despite the headlines. He is also optimistic about a rebound in Japan now that China has spurred the region and "Japanese corporations are investing again."

In terms of emerging-market debt, the T. Rowe fund owns small positions in Mexican and Turkish bonds, as well as a tiny position in the Argentine peso, which Kelson views as 40% to 50% undervalued.

"Our mandate is to give our shareholders exposure into the foreign markets, and that's what we intend to do," says Kelson. His unhedged fund is down 3.87% this year.

The Oppenheimer fund run by Steinmetz, on the other hand, maintains a larger position in emerging market bonds. That emerging-markets exposure boosted the fund to stellar returns of 19% in 2003 and 11.4% and 2004. And while many market watchers are fearful that the unwinding of the carry trade will hurt emerging-market debt, Steinmetz says those fears are overblown.

"Unwinding the carry trade already has hurt emerging-market debt, which means it's yesterday's news," says Steinmetz. "The markets should react less than they did last April, since


tightening is not new news. Indeed, stability is already returning."

Steinmetz holds emerging-market debt from Brazil and Russia and recently added to his position in Polish bonds, on the basis of what he sees as an opportunity to "lock in high real rates in a country with fiscal discipline and falling inflation over the long term."

Steinmetz's affinity for emerging-market debt, in addition to the fund's currency exposure, means his returns can be volatile. The fund returned 26% in 2003 and 15.6% and 2004. This year, though, the fund is down 2.37%.

Another View

Investors unsure whether their stomachs can handle the added volatility that comes from currency exposure can check out the spread between Pimco's hedged and unhedged foreign bond funds. The

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Pimco Foreign Bond (U.S. Dollar-Hedged) fund is up 1.61% this year, while the recently released

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Pimco Foreign Bond (Unhedged) fund is down 3.5%.

Finally, for investors intent on playing the declining dollar who don't care how they do it, Lipper fund analyst Andrew Clark points out that there are more direct ways than buying unhedged world bond funds, including the

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Falling U.S. Dollar ProFund and the


Franklin Templeton Hard Currency fund.

"Use those if you want to play the dollar," says Clark. "Why confound a dollar play with interest rates and national economies? That only raises the degree of difficulty."