Europe's debt crisis takes toll on international bond funds

— -- When you were young, your grandfather told you, "Son, never reach for yield." You passed that advice on to everyone you met, which explains why you didn't have a date until you were 37.

But taking on extra risk for a higher yield really can be a mistake. Today's case in point: international bond funds.

If you depend on interest income for your retirement, you have an enormous problem. The average money fund yields 0.02%, which wouldn't buy dust at a thrift store.

To get more interest, you either have to lock up your money or take the risk of losing part of your principal. But even locking up your cash for longer isn't much help. A 10-year Treasury note now yields about 2% — less than the current inflation rate of 3.5%.

Because rates are so low, income investors have had to take the risk of losing principal. Rates are higher in some places overseas, so mutual funds that invest in international bonds seemed to be a reasonable bet.

The funds, currently yielding about 3%, have been red-hot sellers the 12 months ended Oct. 31, according to Lipper:

•Global income funds, which invest in U.S. and international bonds, pulled in an estimated net $23.9 billion.

•Emerging-markets debt funds attracted an estimated $15.2 billion.

•International income funds saw $4 billion in new money come in the door.

Unfortunately, one area that offered particularly tempting yields was Europe. As the European crisis unfolded, traders dumped their bonds like they were a reality show groom. Prices of European bonds got clobbered, as did many of the funds that invest in them.

The past three months through Friday, international income funds fell 3.8%. For people used to watching the stock market, that's not a tremendous loss. For conservative income investors, however, any loss is bad news. And some funds fared far worse than average:

•WisdomTree Australian and New Zealand Debt fund, down 16.1% the past three months, including reinvested interest.

•Forward Emerging Markets debt, down 8.7%.

•Templeton Global Bond, down 5.9%.

Normally, rising interest rates are the main factor in bond returns: When rates rise, bond prices fall, and vice versa. But European bonds have been hit by worries that they will default — known as credit risk.

Another problem is currency risk. Mutual fund shares are priced in dollars. When foreign currencies fall in value, U.S. investors lose money. Suppose your fund had 1 billion euros in eurozone bonds, and a euro was worth $1.50. The portfolio would be worth $1.5 billion.

Now, suppose the euro falls to $1.34. The portfolio would be valued at $1.34 billion, an 11% loss.

During the debate over raising the U.S. debt ceiling, most people figured the dollar had nowhere to go but down.

When the European debt crisis developed, the dollar rose in value mainly because it wasn't the euro. And until the European crisis is resolved, investors in international bond funds can expect a bumpy ride.

That could be some time. Kathleen Gaffney, co-manager of Loomis Sayles Bond fund, says the fund is largely stepping aside until Europe settles down. Her favorite place for short-term income? Canada. A three-month Canadian Treasury bill yields 0.84%, vs. nothing for three-month U.S. T-bills. (Yep. Zip. Zilch. Nada.)

What's the worst that could happen for international bond investors? A collapse of the euro. Greek bonds have taken a 50% haircut, and Portuguese bonds are also getting clobbered.

If you're considering investing in an international bond fund, take your grandfather's advice and avoid taking on that kind of risk. If you own an international bond fund and you're sitting on a loss, consider selling and taking the tax loss. If you're comfortable with the risk, a eurozone collapse is fairly unlikely, and many portfolio managers have already dumped their riskiest bonds. Just hold on to your hat when the next European summit begins.