Foreign bonds

Most Canadian investors hold Canadian bonds only. However Canadian bonds represent only 2% of the global bond market. It is possible to purchase foreign bonds, from both developed markets such as the US, Europe and Japan, and emerging markets (EM). One way to do this is via exchange-traded funds (ETFs) that trade on the TSX, with exposures to foreign currencies typically hedged to the Canadian dollar. Vanguard estimates that the cost of hedging the currency exposure for global bonds would have been less than 0.1% for the past decade.

Developed markets bonds
Many Canadian investors hold foreign stocks from developed markets, to get the benefit of diversification (see global diversification). Does the same logic apply to bonds, or is it good enough to invest in domestic (Canadian) bonds only? According to Vanguard, writing for a US audience, “investors can now view global bonds as an accessible and viable asset class with the potential to help reduce portfolio return volatility in a manner similar to the diversification benefit expected from international equities”. From a Canadian perspective, there are two types of investible foreign developed markets bonds: US and non-US, each of which has potential diversification benefits, if the currency exposure is hedged (unhedged foreign bonds have currency risk, so they are not good “safe” complements to domestic bonds; see Currency hedging for foreign bonds).

Another argument in favour of global bonds is that during bear markets for stocks, relative to Canadian bonds, "hedged global bonds have provided better median outcomes as well as a much tighter distribution of returns, meaning more consistency for investors during poor equity market returns". Nevertheless, Vanguard also notes that “correlations across developed markets have displayed a persistent rising trend in both equity and fixed income markets”.

On the other hand, there is a case to be made for simplicity, especially for smaller, stock-heavy portfolios. This would probably exclude developed market foreign bonds from consideration. For such portfolios, Canadian bonds are probably good enough diversifiers. As shown in Reducing portfolio volatility: adding foreign bonds, addind US bonds for example leads only to a small decrease in portfolio volatility for bond-heavy allocations, and the effect is negligeable for stock-heavy portfolios. Furthermore, the costs of accessing foreign bonds is likely more than that of accessing domestic bonds.

However “say you have $2 million and a target asset mix of 70% bonds and 30% equities. Now your fixed income allocation is a hefty $1.4 million, and a shock to the Canadian bond market would deal a swift kick to your net worth. In that situation it does make sense to divide that among Canadian, US and international bonds to reduce your risk”.

Two Vanguard Canada ETFs trade on the Toronto Stock Exchange and invest primarily in the equivalent US-domiciled ETFs, which themselves hold thousands of issues: Both of these ETFs use currency hedging.
 * U.S. Aggregate Bond Index ETF (CAD-hedged), management fee 0.20% (VBU)
 * Global ex-U.S. Aggregate Bond Index ETF (CAD-hedged), management fee 0.35% (VBG)

BMO and iShares offer a number of US corporate bond ETFs, with and without hedging back to CAD.

Emerging market bonds
EM bonds mostly consist of government issues, with less than 10% corporate bonds. Most of the government bonds are investment grade.

The yields on EM bonds are typically higher than those on government bonds from developed countries because EM bonds are considered riskier. The main extra risk is credit risk “stemming from political, regulatory, or market/macroeconomic developments”.

Governments defaulting on their debts is the most serious manifestation of credit risk, and has happened often in the past with EM bonds, more often then their debt/GDP ratios would predict. This is why the market demands higher yields.

EM bonds can either be denominated in local currency or in “hard currencies” such as US dollars. The former are subject to currency risk. For Canadian investors, US dollar-denominated bonds can be hedged to Canadian dollars, as done by the two ETFs listed below, mostly eliminating currency risk and leaving only credit risk to worry about.

Over the period of 1994-2012, EM bonds have outperformed stocks with a higher return (10.12% annualized) and lower standard deviation (12.15%). Correlations with US bonds and non-US developed markets bonds were low, and correlations with various types of stocks were moderate. This makes EM bonds look very attractive, but the future may not look like the past.

Two emerging market bond ETF are available on the Toronto Stock Exchange, and both are CAD-hedged:
 * BMO Emerging Markets Bond Hedged to CAD Index, management fee 0.50% ZEF
 * iShares J.P. Morgan USD Emerging Markets Bond Index ETF, management fee 0.52% XEB

ZEF holds over 50 bonds directly, whereas XEB is a clone of US-domiciled iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB), which itself contains over 300 issues.