The case for investing in global bonds

Plus: The case for choosing hedged instead of unhedged bond funds

Many long-term investors take a balanced approach to meeting their investment objectives, which generally means holding a mix of equity and fixed-income investments (stocks and bonds) in addition to some cash-based investments. Stocks provide growth, while bonds generate income and add stability by mitigating equity volatility.

When it comes to investing in stocks, many Canadians accept the rationale for looking outside our borders. With Canada representing just 4% of the global stock market, investing in U.S. and global stocks adds diversification to boost portfolio performance through all kinds of market conditions.

Reasons to explore the 98% of bonds issued outside Canada

The same rationale applies to bonds. From a global perspective, Canadian bonds represent only a small, concentrated portion of the global bond market—around 2% . Yet, investors who maintain a balanced portfolio often stick to Canadian content for their fixed income allocation.

If you own only Canadian bonds, you’re at the mercy of the risk factors in our single market. And while Canada has a relatively safe and stable market, it has historically been more volatile than the broader global bond market. 

Investing a portion of your fixed-income allocation outside of Canada gives you exposure to sectors that are not well represented domestically and reduces your exposure to monetary policy action executed by a single central bank. It also increases the potential for earning higher interest rates as yields may be more attractive in other countries. Overall, increasing your fixed-income diversification could allow you to achieve better risk-adjusted returns. 

The impact of currency fluctuation

For most investors, ETFs and mutual funds provide the simplest and most cost-effective way to build a fixed-income allocation. There are many funds that provide access to U.S. and global bond markets. But before you commit, there is one very important consideration: currency fluctuation. 

Investing outside Canada entails owning bonds whose interest and principal are denominated in other currencies. The value of those currencies continuously fluctuates against the value of the Canadian dollar. Sometimes that fluctuation is favourable, and sometimes it isn’t. When the loonie rises against a foreign currency, the value of investments denominated in that currency falls in Canadian dollar terms. Conversely, when the Canadian dollar loses value relative to a foreign currency, you see a boost in the value of foreign investments in that currency. Over the long term, those currency effects tend to cancel each other out. However, all that additional fluctuation adds a lot more volatility to your portfolio than you would expect to see if you only invested in Canadian bonds.

Hedging away currency volatility

Is there a way to invest in foreign bonds without worrying about currency fluctuations? Yes: you will notice that that US and global bond funds are either hedged or unhedged. Unhedged funds are fully exposed to currency fluctuations while hedged funds are protected through the use of contracts, called currency forwards, which lock in exchange rates. Those transactions add a small additional cost to the portfolio,  but deliver the benefit of essentially eliminating the impact on the fund from fluctuating exchange rates. 

To give you a sense of the difference hedging makes, consider that for Canadian investors the volatility of unhedged US bonds has historically been over three times higher than the same US bonds where the USD/CAD currency exposure has been hedged. Historically, that additional volatility from unhedged exposure has not been adequately compensated by additional returns.

Volatility (standard deviation): Canadian vs unhedged and hedged US bonds

Risk-adjusted returns: Canadian vs unhedged and hedged US bonds

The bottom line is that for balanced investors, there’s a good rationale for gaining exposure to global fixed income markets, while historical data suggests that using hedged investments is likely to provide a more efficient outcome. While unhedged bonds might provide higher returns over time vs hedged bonds, those additional returns come with uncompensated volatility. Past experience suggests that the best balance between risk and reward is likely to come from hedged bonds.