By Martin Hutchinson
Contributing Editor

In a recent column, I suggested that investors seeking income (which means most of us aged 55 or older) could do better in foreign stocks than in domestic shares, especially since options-obsessed corporate managers have slashed U.S. dividend payouts in order to protect their yearly bonuses.

In this column we’re going to explore income alternatives available from short-term investments in foreign currencies, a strategy that capitalizes on both the general sogginess of the dollar and the higher yields available from some markets abroad.

Investments in short-term foreign-currency assets can potentially offer much better returns than U.S. investments for income investors, for the following reasons:

• The United States continues to run a $700 billion payments deficit annually. While that continues, the dollar will tend to be weak against other currencies. Sometimes, even low-risk investments in the right foreign currency can provide substantial capital gains – and it’s not always the obvious currencies. Did you know you could have made over 30% in dollars over the past year from a bank deposit in Czech crowns? And that wasn’t some wild-eyed risk; the Czech Republic is a perfectly solid middle-income democratic EU member with an admirable free-market president, Vaclav Klaus.

• Because U.S. interest rates are so low, many countries have higher interest rates right now, but without the escalating rates of inflation that currently appear to be afflicting the U.S. economy. Australian, Brazilian and New Zealand bank deposits all pay more than 5%. All three currencies have recently been strong against the dollar, and that’s likely to continue, even as the inflation rates in these countries remains comparable to, or lower than, that of the United States.

Foreign currency short-term assets are ideal for that portion of an investment portfolio that seeks to avoid exposure to both the risks of equity markets, and to the risks of global inflation. For the income investor who is seeking to live off some of the returns on his investments, a portfolio with too much investment in stocks – domestic or international – is vulnerable to a general global downturn, when worldwide stocks may decline in price and force investors to sell at the bottom of a bear market. International investments in bonds suffer if inflation rises, because bond yields are forced higher, causing capital losses on bond investments.

But international investments in short-term instruments do not suffer either penalty. They are safe from stock market downturns. They are also safe from inflation, since short-term investments are continually reinvested, and in an inflationary period the new investments will generally offer higher yields, offsetting the inflationary erosion in purchasing power.

As an illustration, remember that when U.S. inflation hit 10% in 1980, short-term-investment yields rose as high as 17%, providing investors with an ample return to cover inflation’s cost.

Investment in international short-term instruments or deposits is not the same as buying a money market fund; their dollar value will fluctuate as the dollar fluctuates in value against other currencies. Needless to say, in a period such as the present (when the dollar is generally weak), the strategy that I’m detailing here can provide additional capital gains for the dollar-based investor.

There are two ways easily available to U.S. investors to invest in foreign currency short-term assets:

• One is to invest in foreign currency deposits. These are available through Everbank, with which Money Morning has a relationship. Because Everbank is a U.S. bank, its foreign-currency deposits benefit from a guarantee by the Federal Deposit Insurance Corp. of up to $100,000. Everbank offers deposits of 3-, 6-, 9- and 12-months’ maturity in a number of foreign currencies, with a minimum investment of $10,000. For example, Everbank currently offers deposit yields of 5.5% in Australian dollars, 6.13% in New Zealand dollars, 4.25% in Norwegian krone and 8.75% in South African rand, compared with deposit rates of around 3% to 4% available in the domestic U.S. market. All those currencies appear to have good prospects to rise against the dollar over the next 6-month period, except the South African rand where local inflation is above 10%.

Everbank also offers a range of multi-currency-index CDs, which provide currency diversification as well as an attractive yield. For example, its commodity index CD – containing equal amounts of Australian dollars, Canadian dollars, New Zealand dollars, and South African rand, with a yield of 5.5% – might be expected to appreciate against the dollar in periods such as the present when commodity prices are rising and commodity-based economies are doing well.

The main disadvantage of the Everbank system is that your money is physically converted into foreign currencies, incurring a foreign exchange cost of up to 1% in the process. For short-term deposits, this obviously can be expensive.

• The other possibility is to invest in one of the funds that have recently opened that specialize in investments in short-term foreign currency assets.  These funds have the advantage of being quoted in dollars, so there is no foreign-exchange cost in purchasing them. Three of these in particular appear attractive:

• • The Franklin Templeton Hard Currency Fund (ICPHX), part of the well-known Franklin Templeton group, rated as a five-star fund by Morningstar, has a minimum investment of $1,000, but the disadvantage of a 2.25% front-end “load.” That load, or fee, is important when considering an investment in short-term assets. There is also the “advisor-class fund” (ICHHX), with identical holdings and a minimum investment of $50,000. This has no front-end load, but it appears you have to buy it through a broker, incurring additional costs. The two funds have combined assets of $693 million and were established in 1989. ICHHX has an average annual return of 7.76% over 3 years, and a yield on a trailing-12-month basis of 7.75%. The funds invest primarily in hard currency (low inflation) deposits and short-term bonds, with an average maturity of 0.16 years (2 months) – they may invest 20% of their funds in other assets, such as gold and inflationary currencies.

• • Specialist currency fund manager, Merk Investments LLC, offers the other two funds. The Merk Hard Currency Fund (MERKX), founded in 2005, also is given a five-star rating by Morningstar, and has $435 million of assets invested in hard currency short-term bills offered by governments and prime corporations, as well as modest holdings of gold. It is up 11.62% over 3 years and offers a yield of 6.79% on a trailing 12-month basis. It has no sales load and a minimum investment of $2,500.

• • The Merk Asian Currency Fund (MEAFX), was established only in April 2008, too recently to have obtained a Morningstar rating or reliable performance data, and has assets of only $45 million. Its attraction is that it specializes in short-term instruments in Asian currencies; at present, for example, it has 41% of its fund in short-term Chinese Renminbi (yuan). Again, the fund has a minimum initial investment of $2,500 and no sales load.

[Editor’s Note: When it comes to global income issues, Money Morning Contributing Editor Martin Hutchinson knows his stuff.  An investment banker with more than 25 years’ experience, Hutchinson has worked on both Wall Street and Fleet Street and is a leading expert on the international financial markets. In February 2000, as an advisor to the Republic of Macedonia, Hutchinson figured out how to restore the life savings of 800,000 Macedonians, who had been stripped of nearly $1 billion by the breakup of Yugoslavia - and then the Kosovo War. Hutchinson’s "Insights on Income" column will now be a regular feature in Money Morning].

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