Talk about learning the value of a dollar the hard way.

Investors seeking to profit from a declining U.S. currency by piling into international bond funds are discovering that the currency markets dance to their own tune. The dollar's unexpected bounce in 2005 -- even in the face of severe pessimism -- has sent the average world bond fund down slightly over 2% this year, according to Morningstar.

One fund manager well-schooled in the power -- and peril -- of currency speculation is Pimco's Sudi Mariappa. Mariappa has to be on top of all the details because he runs both the

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Pimco Foreign Bond (U.S. Dollar Hedged) fund and its recently released counterpart, the

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Pimco Foreign Bond (U.S. Dollar Unhedged) fund. The hedged version is up 1.61% this year, while the unhedged fund is down 3.5% -- which just goes to show how much a volatile currency can cost an unwitting investor.

Mariappa expects the pressure on the dollar to resume over the long term, and he says buying an unhedged international bond fund is an efficient way for educated investors to play the trend. Mariappa shared some of his views in an interview with


Many investors are buying international bond funds in order to play the weakening dollar. What do you think of this strategy?

Sudi Mariappa

Source: Pimco

For those investors with the ability to take greater risk, foreign currencies can be a good source of returns. And given their low or negative correlations to stocks and bonds, they can be a good source of diversification as well.

An unhedged international bond fund is among the more efficient ways to gain this exposure. To avoid getting caught up in the dollar's daily ups and downs, we suggest that investors adopt a longer-term focus and size their investment in unhedged international bonds based on their risk tolerance.

What is your view of the dollar's strength or weakness?

Despite three years of declines, and notwithstanding the strong start this year, Pimco anticipates that the U.S. dollar will remain pressured by current account and budget deficit concerns. We take a longer-term view on the dollar, and over a secular horizon think that the dollar will be one of the main adjustment mechanisms as the global imbalances unwind.

How does this reflect on the strength of the U.S. economy?

The U.S. economy's recent growth momentum should be sustained on the continuing handoff from the government to the corporate sector. Strong profits will enable the corporate sector to become more expansive. The key word is "modest." Modest payroll and wage growth will support confidence and consumption. Rising unit labor costs and the flow-through of higher commodity prices could pressure core inflation.

What is your forecast for interest rates in the U.S.? Why won't long-term rates rise, despite the Fed's attempts to raise them?

Despite upward pressure on inflation, we expect Fed policy to remain measured. Despite fears that inflationary pressure is building, core inflation releases have actually been quite benign, and hence longer-term rates have stayed relatively low. On balance, it is also fair to say that the heavy buying of Treasury securities by offshore players including central banks is providing support to the U.S. yield curve.

Germany and France are facing tough economic times with high unemployment. Could we see rate cuts over there?

We expect that growth in the euroland region will remain subdued as consumer spending and investment recover slowly. The ECB has already stated that its next move in rates will be a hike, so unless there is a very sharp contraction in the economy, we don't anticipate a rate cut.

However, what we do worry about is the prospect of a policy mistake, namely a premature rate cut. But for the most part, we think the ECB will keep rates on hold for the better part of 2005 and let the economy work through some of its structural overhang before raising rates.

Japan's economy also seems to be having problems again. How will this affect your Japanese holdings?

Japan's economy is still dependent on external demand to drive growth. In the past couple of years, corporate profits have been very strong and have resulted in a pickup in capital expenditures. But household incomes have been weak. However, Japan's X-factor is that domestic conditions are in the best shape in over a decade. Bank and corporate balance sheets are healthier. The accounting nonsense from the past is now much more transparent. There is job growth, but wage growth is weak. That makes it tough to forecast inflationary pressure.

In that environment, we expect the Bank of Japan to remain accommodative, as core CPI is unlikely to sustain a positive reading in the near term. Our positioning in the Japanese market is more bottom-up strategies geared to benefit from the steep yield curve. We think that the yen is likely to strengthen and so think there is value in long yen currency positions.

Many people say the unwinding of the carry trade will hurt emerging-market debt. What is your opinion of emerging-market bonds? Which countries show the most promise?

We've already seen EM debt spreads widen as Treasury yields rise and market volatility picks up. While investor risk-aversion will always impact the near-term movements in EM, from a longer-term perspective we are very favorable on EM as an asset class. Underlying fundamentals in EM countries, especially in the higher-quality cohort that Pimco focuses on, remain solid.

One example: In just the first 10 weeks of 2005, Brazil's reserves have grown by $10 billion. Higher commodity prices also continue to bolster the fundamentals of commodity producers like Russia. From a technical perspective, approximately 65% of EM countries' 2005 debt issuance has already been completed. We think that Brazil, Russia, Peru, Panama and Mexico are fundamentally solid credits and ones that are going to perform well in the longer time horizon.