Global bonds: What you need to know

Q: I was surprised to see a Vanguard infographic pointing out that international [non-U.S.] bonds are the largest asset class in the world. Do you have any thoughts on why Canadians have not embraced international bonds in their portfolios?—A.M.

While stocks grab all the headlines and dominate the conversation among investors, the bond market is vastly larger. Yet while a diversified index portfolio can include 10,000 stocks from over 40 countries, chances are your bond holdings are entirely Canadian.

There are some good reasons for a strong home bias in bonds. The main one is currency risk. Exposure to foreign currencies benefits an equity portfolio by lowering volatility (at least for Canadian investors), but taking currency risk on the bond side is usually a bad idea. Because currencies are generally more volatile than bond prices, you’d be increasing your risk without raising your expected return. That’s a bad combination.

It also gets to the heart of why few Canadians have international bonds in their portfolios: there just aren’t many good products offering global bond exposure without currency risk. iShares and BMO have a number of ETFs covering U.S. corporate and emerging markets bonds. But if you wanted to build a low-cost, diversified, currency-hedged portfolio with high-quality bonds from around the world, it was hard to do so until this summer. The wait ended in June with the launch of the Vanguard U.S. Aggregate Bond (VBU) and the Vanguard Global ex-U.S. Aggregate Bond (VBG), both of which are hedged to Canadian dollars.

(Another option is the global fixed income funds from Dimensional Fund Advisors. However, these funds are not available to do-it-yourself investors.)

Now that international bonds are available to all Canadian investors, should you rush to build a globally diversified fixed income portfolio? For most people, the answer is probably no. The benefits of holding non-Canadian stocks is enormous, as equity returns vary widely from country to country. But the diversification benefit of international bonds is likely to be much more modest. Here’s how the broad Canadian bond market stacked up against a global index over various periods ending in July 2014:

Source: FTSE TMX Canada Universe Bond Index (formerly the DEX Universe Bond Index) and Barclay’s Global Aggregate Bond Index (Hedged to CAD). Data from Dimensional Returns 2.0.

If you’ve got $100,000 and a 30% allocation to bonds, a global bond holding is probably not worth the added complexity and cost. But the argument for adding global bonds is much stronger for those with very large portfolios and a higher allocation to fixed income. 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, U.S. and international bonds to reduce your risk.

Dan Bortolotti is the consulting editor of MoneySense. He blogs here and at canadiancouchpotato.com. Find him on Twitter @CdnCouchPotato.