Q: One of my coworkers and I recently started our own Couch Potato portfolios and we’re wondering if it would be better to have some American bonds in the mix. Wouldn’t that be another way to diversify? – Jason L.

The answer depends on whether you’re talking about government bonds or corporate bonds.

It’s usually not a good idea for Canadians to hold US or other foreign government bonds in their portfolio. In theory, because interest rates are not the same in every country, it can makes sense to diversify your bond holdings globally. However, investing in US or international bonds exposes Canadians to currency risk.

Currency risk is welcome on the equity side of your portfolio, because it can lower volatility without decreasing expected returns. That’s why I recommend using unhedged index funds and ETFs for US and international stocks. But the situation is different for fixed income. The yield differential between Canadian and US bonds is likely to be quite small, and it will be completely overwhelmed by significant changes in the exchange rate. That means adding currency risk to your bond holdings will tend to increase volatility without increasing expected returns. That’s clearly a bad combination. (For an excellent discussion of this idea, see this Vanguard research paper.)

A solution, of course, would be to add currency hedging. That’s what Dimensional Fund Advisors does with its Five-Year Global Fixed Income Fund: “This enables us to gain the benefits that come from diversifying across many countries without measurably increasing currency risk.” However, there are currently no ETFs or index funds that holds US government bonds with the currency hedged to Canadian dollars. So in practice, this asset class is closed to most Canadian investors.

More options for US corporate bonds

The situation is quite different for corporate bonds. There is an even bigger diversification benefit to looking south of the border for this asset class. The Canadian corporate bond market is very small compared with that of the US (especially in high-yield bonds) and the interest rate trends are significantly different in the two countries.

What’s more, there are several index ETFs that allow Canadians to buy US corporate bonds with currency hedging, including the iShares U.S. IG Corporate Bond (XIG), the iShares U.S. High Yield Bond (XHY), and similar offerings from Claymore and BMO. These are reasonable holdings for Canadian investors who want to diversify their corporate bond holdings without taking currency risk.

Got a question about index investing? Send it to mail@hht.df7.myftpupload.com and it may be answered in a future installment of “Ask the Spud.” Answers are provided as information only and do not constitute investment advice.