As the US dollar comes under pressure from the mounting debt burden of the federal government and investors recover some of their risk appetite, yields on US Treasury debt are gradually creeping up.

That situation won’t hold for long, as the rising yields on US government bonds are likely spur the Federal Reserve to ramp up its purchases of Treasury notes; cheap and easy money is still the cornerstone of the government’s recovery program. And real estate continues to be a key area of concern despite preliminary signs of stabilization, meaning it’s in the government’s interest to keep rates low.

In response to those pressures, international debt has been one of the best plays in the bond markets. Below we outline conservative and slightly more aggressive ways to dip your toes in international waters.

Fidelity Total Bond (FTBFX) is an excellent way to play foreign debt markets without adding too much risk. The bulk of the portfolio is highly rated, with 87 percent of its holdings deemed investment grade. Of that, more than 60 percent of the portfolio earns AAA ratings, with US Treasuries accounting for 10 percent of its holdings. A further 10 percent of the portfolio comprises bonds issued by foreign governments and corporations. From there, a third of its holdings are solid-gold corporate bonds dominated by names like McDonald’s (NYSE: MCD) and Altria (NYSE: MO) as well as a variety of utilities.

That high quality provides a solid base for the portfolio, generating dependable coupons and tapping into the hot Treasuries market. About 10 percent of its holdings are junk bonds, issued primarily by financials. Those add a bit more than 1.5 percent to the fund’s overall yield of 5.5 percent, one of its most attractive features. You get exposure to the full spectrum of credit quality without overweighting the riskiest of issues.

Another selling point is manager Ford O’Neil, who has generated and outperformed his benchmark in most years. The exception was 2007, when O’Neil underperformed the Barclays Capital Aggregate Bond index by 2.8 percent after a small position in subprime mortgage bonds moved against him.

Since then he’s trimmed the worst offending mortgage issues from the portfolio and moved to minimize credit risk, though he still holds a large volume of mortgage bonds and pass-throughs backed by Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE). For all intents and purposes, those pass-throughs now have the backing of the federal government.

Last year was the fund’s worst year ever, as it gave up a bit more than 5 percent on a total return basis. The fund held a variety of bonds rather than focusing on a single class, but that commitment to diversity caused the fund’s returns to lag its intermediate- term bond peer group by less than 1 percent.
Going forward, there’s no arguing with the fund’s diversification, which leaves it well positioned to take advantage of any further improvement in the credit markets. It also sports an attractive average duration of 4.5 years. Although there will be some effects from rising interest rates, the fund won’t be crushed like some of its shorter-term brethren.

Out-yielding the average Treasuries only fund by more than two percent, all these positives stack up to make the fund an excellent core holding for the fixed-income portion of any investor’s portfolio.

A more aggressive way to play foreign debt is T. Rowe Price International Bond (RPIBX). Holding no US government debt and with only a small fraction of its holdings US dollar denominated, the fund has essentially no exposure to the dollar’s woes. And it offers a slightly larger safety net, being more heavily invested in developed markets than emerging ones.

WHY TO BUY

FIDELITY TOTAL BOND (FTBFX)
T. ROWE PRICE INTERNATIONAL BOND (RPIBX)
o US dollar remains under pressure
o Further Fed buyback programs likely
o Paltry yields on US debt