Clients dissatisfied with the skimpy returns on Canadian fixed-income securities may want to add some juice to their portfolios through global exposure, and possibly a dash of emerging markets.
Canada represents only 2.7% of the global fixed-income market, yet research shows Canadian mutual fund investors have 75% of their fixed-income assets in Canadian securities.
By contrast, on the equity side, Canadians have been heeding the message about the risk and return advantages of international diversification, and are closer to a 50/50 split between Canadian and global mutual funds.
Canadians are failing to take advantage of the full spectrum of almost 16,000 issues across 70 countries, as measured by the Barclays Global Aggregate Bond Index, says Daniel Solomon, chief investment officer at Toronto-based NEI Investments, a division of Northwest and Ethical Investments LP. NEI offers NEI Global Total Return Bond Fund, managed through a sub-advisor relationship with Amundi Asset Management of Paris.
“There are limited opportunities in the Canadian fixed-income market, but Canadians are missing out on the advantages of global diversification,” says Solomon. “With a global portfolio you are not forced to own government bonds yielding almost nothing, you can move to places with better interest rates, or more opportunity to make capital gains.”
Fixed-income investing is becoming increasingly challenging, and when looking abroad, Solomon says it’s important to consider many factors, including credit quality, duration and the political and currency risks of individual countries.
Corporate bonds generally yield higher than government bonds in most countries, and as corporations become more global in scope, investors can dilute some of the individual country risks, he says.
Some of the opportunities offer enticing income advantages. For example, 10-year government debt in Mexico offers a generous annual yield of about 5.9%, while Canadian government 10-year bonds are currently yielding a scant 1.3% annually. Even short-term government debt in Mexico, which poses less duration risk than long-term debt and offers more flexibility, is paying a higher yield than long bonds in many developed countries.
Currency can present a significant risk in global bond portfolios, as currencies can be even more volatile than bonds, according to NEI’s research. However, currency hedging can significantly reduce this volatility.
For instance, fully hedging the currency on the Barclays Global Aggregate portfolio during the 10 years ending June 30, 2014 would have reduced currency volatility by more than 70%, making the volatility of the actual bond portfolio less than a pure Canadian portfolio as measured by the FTSE Canada Universe bond index.
Emerging markets represent an increasingly prominent component of the global bond market. Total emerging market tradable debt outstanding rose to US$16.4 trillion in mid-2015 from less than US$6 trillion in 2005, according to Bank of America Merrill Lynch Global Research data.
“Emerging markets bonds offer significant yield pick up over traditional asset classes, which is especially relevant at today’s low level of interest rates globally,” says Christine Tan, senior portfolio manager at Excel Investment Counsel Inc. of Toronto. “Not only do they provide substantially higher yields but they have a low correlation to other asset classes. This reduces the overall volatility of a portfolio, an important feature for fixed-income investors, who are typically more focused on low volatility than huge returns.”
The quality of bonds from these markets is on the rise, Tan says. As countries move toward becoming more politically and economically stable, credit ratings improve and currencies stabilize.
It’s important to remember that many emerging markets are at a less mature stage of development, and the road to maturity could be bumpy. Nevertheless, some emerging countries are now judged by rating agencies to be less risky borrowers than many developed countries. Many emerging countries have high levels of foreign reserves, Tan notes, giving these countries the ability to repay foreign debts and stabilize exchange rates.
A handful of emerging market bond funds is available to Canadians from sponsors including Excel Funds Management of Mississauga, Ont., AGF Funds Inc., RBC Global Asset Management, Invesco Ltd. and Manulife Financial Corp. Investors can also get exposure to both global and emerging markets bonds through exchange-traded funds.