COVER STORY

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With interest rates in the U.S. and other developed economies near record lows, earning attractive levels of income from your bond holdings can be a challenge. Mutual funds that invest in high yield securities and emerging markets offer opportunitiesand can help diversify your portfolio.

Bonds are part of the foundation of a long-term investment strategy. They are usually less volatile than stocks and provide an important counterweight to the volatility of investing in the stock market. Choosing the right blend of bonds—and properly diversifying your fixed income holdings—can be a challenge: The range of investment options has grown significantly in recent years and has become more complex. Fully understanding the factors that influence each type of bond requires constant research and professional management.

While many investors are familiar with U.S. Treasuries, which provide a high degree of credit security, they may be less knowledgeable about other classes of fixed income securities. High yield bonds and emerging markets debt are two areas that offer higher yields but have more credit risk than government bonds. T. Rowe Price has expanded its fixed income research team to more thoroughly appraise the growing opportunities around the world, manage risks, and implement investment strategies. "One of our strengths is that we have a very big research staff—and we're continually adding to it," says Ian Kelson, London-based president of T. Rowe Price's International Fixed Income Division. "With our capabilities, we've been able to seize many opportunities in the global fixed income marketplace."

BOND BASICS

With interest rates near historic lows, research teams and fund managers seek investments that can help increase returns without taking on excessive risk. Whether you are seeking domestic or international securities, bond investing always involves credit and interest rate risks. Credit risk is the possibility of a downgrade from a credit rating agency or an actual default if the issuing entity is unable to make interest or principal payments. Interest rate risk is normally a function of the economy and the actions taken by central banks. If an economy is expanding too quickly, central bankers generally raise interest rates to temper economic growth and dampen inflation, which diminishes the real return of an investment. When inflation or interest rates rise, bond prices fall—and when interest rates fall, bond prices rise.

Risk vs. Return. The fundamental principle of investing in bonds is risk versus return—investors typically receive higher yields for assuming greater credit risk. The biggest and most liquid market in the world is the U.S. Treasury market. Treasuries are viewed as one of the safest investments because they are backed by the full faith and credit of the U.S. government. Investment-grade domestic and foreign corporate bonds—securities issued by companies— usually offer higher interest rates compared with Treasuries of similar maturity because, without the backing of the government, they have greater credit risk. Between Treasuries and corporate debt are securities issued by agencies such as Ginnie Mae that offer higher interest rates than Treasuries and still have the backing of the federal government. Investors would still be vulnerable to rising interest rates, but credit risk should be minimal—unless the government defaults. Bonds in emerging markets, where political and social upheaval are more likely, have greater volatility. However, with the added level of uncertainty comes the possibility of higher returns. "Risks are also potential opportunities," Kelson notes. "They just need to be managed."

INVESTING IN BONDS THROUGH MUTUAL FUNDS

Mutual funds offer the best opportunity to capitalize on the potential of fixed income investments—particularly in emerging markets. International fixed income markets can be extremely complex and usually require the experience and research capabilities of investment professionals. Gaining access to these markets is beyond the reach of most individual investors, and staying current in an ever-shifting financial landscape is challenging.

T. Rowe Price investment professionals diversify portfolio holdings to manage risks as they seek to produce above-index returns. An international or global fund diversifies by region and credit quality. Spreading assets throughout the global marketplace helps reduce the impact of an unforeseen political or economic event, or natural disaster. "When we see risks, we try to adapt," says Kelson, who is also portfolio manager of the T. Rowe Price International Bond Fund (RPIBX). "For example, we reduced the fund's position in the euro and in markets such as Spain last year due to the widening European debt crisis."

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