Why fixed income investors should consider loading up on foreign bonds

Canadian investors tend to stick close to home when buying bonds and other fixed-income investments, but diversifying is worthwhile if you do your homework

Investor with shopping cart full of Canadian bonds inspects alternatives

(Illustration by Iker Ayestaran)

Diversifying geographically is an axiom investors know and, to a degree, follow on the equity side of their portfolios. But what about fixed income? For generations of Canadians, that was the preserve of Government of Canada bonds. Even today, most investors rely on a domestic mutual or exchange-traded bond fund or two, preferring to avoid any currency risk. Especially now, with a third of the world’s sovereign bonds carrying a negative yield, why would you want to hold foreign paper?

The choices are limited today, concedes Dan Hallett, vice-president of HighView Financial Group, but there’s still a case to be made for spreading your fixed income around. For one thing, those 10-year Canada bonds are yielding just 1.14% and could lose value should interest rates rebound from their recent lows, as many market-watchers expect.

Overall, foreign notes are no more appealing, yielding less than 1% per year, Hallett says. But there is a corner of the market where investors can earn a better income: emerging markets. The JPMorgan Emerging Markets Bond Index Global, a U.S. dollar-denominated index of 65 emerging-market countries, yields about 5%. To many investors, that’s starting to look pretty attractive. Over the first eight months of the year, US$25.3 billion flowed into the bonds of developing nations—a complete reversal from the US$25 billion in net ouflows in 2015 and the most money the asset class has taken in since 2012, according to Morningstar.

“Emerging-market debt is one of the few large, liquid assets that offer investors significant yield,” says Sergei Strigo, head of emerging market debt and currency with Amundi Asset Management. And while there are added risks to consider before buying this asset class, it may not be as big of a leap as it once was.

The big fear has always been the higher risk of default. In reality, though, most foreign bonds do mature. So far this year, not a single bond from an emerging nation has defaulted, while 2015 saw just one, an issue from Ukraine, go bust, according to Moody’s Investors Service. Many of these economies have become more sophisticated, their debt-to-GDP ratios have come down and pro-business governments have boosted growth.

A number of these nations have also adopted independent monetary policies. Their interest-rate moves used to follow the U.S. Federal Reserve, but more country-specific issues have forced central bankers to do what they think is best for them. That has caused some European states to institute negative rates, but it’s also allowing central banks in emerging nations, such as Brazil and Russia, to ease their own sky-high rates—and that could give bonds in these countries an added boost, says Chia-Liang Lian, head of emerging markets debt at Western Asset Management in Pasadena, Calif.

The biggest risk to Canadian investors may not be the default rate at all, but rather currency moves. There are currently no emerging-market fixed income products denominated in Canadian dollars; investors have to buy either American dollar securities (also called hard dollar bonds) or the local currency option. Both come with exchange risks, but U.S. dollar bonds are usually less volatile than those denominated in local currency, says Lian.

“Currency has the highest sensitivity to sentiment,” Lian says. “So when there’s an event shock, that tends to be reflected very quickly in equity prices, as well as in currency.” Another advantage of hard dollar bonds: It’s relatively easy for Canadians to grasp movements in the greenback; most people aren’t watching where the Brazilian real goes on a regular basis.

In any case, retail investors will find it difficult to buy foreign bonds on their own. These securities are usually more expensive when bought individually, and you would have to be extra savvy to know how to buy a product from, say, China, Russia or even France. An easier option is to purchase a bond ETF or mutual fund focused on a country or region. Some fund managers will try to hedge the currency risk, says HighView’s Hallett, but it is a complicated process, and every manager takes a different approach. Investors should have some of the portfolio hedged—a hedge on half could make sense, as that would essentially be a neutral call on currency, he says—but whether an entire basket of bonds is hedged is up to the manager.

Those who want to buy a specific country bond fund should use a little money from their fixed income allocation and a little from their equity allocation, says Hallett. This kind of debt has equity-like properties, so it should be treated as a hybrid investment and not simply as another bond, he explains.

A better option, in Hallett’s opinion, is an actively managed global bond fund, in which the manager can move in and out of countries as he or she sees fit. Holders get a diversified basket of securities that could include more developed nation products as well. “You want greater flexibility and a broader mandate,” he says. “So when the opportunity looks more attractive, there will be some money directed to emerging-market bonds, and when there’s not enough compensation for the risks, then they could have little or nothing in these bonds.” As always, avoid funds with high fees.

A 3% to 5% allocation to foreign bonds would be appropriate for most investors, says Lian, though you could go higher if you can stomach more risk. As long as domestic returns stay low, expect more investors to look further and further afield for yield. “The emerging-market debt picture is very positive,” says Strigo. “And we think these inflows will continue.”