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 firstname.lastname@example.org 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.
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I would argue that a lot depends on what your investment plans are. If you plan to retire abroad then having a substantial portion of your money in US currency (either in cash or US bonds) makes perfect sense. The US greenback is as close to a universal currency at this point as we can expect to get.
The second reason for having US bonds is that when a panic sets in in the equities market investors run to the safety of US treasuries. Nobody runs into the safety of Canadian treasuries. Regardless of what you think about the trustworthiness of the regime in Ottawa there isn’t even enough room there to absorb a significant portion of the money flowing out of equities. So as a portfolio balancing tool that smoothes out the market bumps, US bonds appear to be much better.
Finally, corporate bonds should not be purchased by anybody ever. What’s the point? If you have faith in a company (or a sector or the whole market index) just buy the equities. Being a corporate bondholder you assume all the risk of investing in a private venture with only a reduced benefit (you get no share in the growth of capital gains).
Thanks for the opportunity to win TurboTax Premier Online.
@Bill Gates: Thanks for taking a break from your charitable foundation to visit the blog. :)
I agree with your first argument completely. If you have US dollars and want to grow that money with the plan of eventually spending it as US dollars, then it makes perfect sense to invest in US-denominated bonds.
I’m not sure I agree with your second argument. In the event of a market meltdown like we had in 2008–09, Canadian government bonds provided a huge safety net: you didn’t need US Treasurys to get that diversification benefit. It’s true that some exposure to the US dollar would have helped further, but investors could have (and should have) got that exposure on the equity side of their portfolios.
As for corporate bonds, there are many smart folks who agree with you, including David Swenson at Yale, though for different reasons, I think. (Remember that if a company goes bust, its bondholders are first in line and equity holders may get nothing.) Swenson’s argument has more to do with the idea that investors are not rewarded for taking extra credit risk compared with government bonds. I’m more agnostic about this. I think investment-grade corporate bonds are perfectly fine, though not essential, in a diversified portfolio.
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The US Bond section of my portfolio I trade using TLT iShares Barclays
Brought TLT in July 2011 $95 US @ 1.05 US. to Cdn.
Sold TLT in November 2011 $120 US @ ).97 US to Cdn.
Capital gain 26% plus 8%-3%(fee)= +5% (currency) = +31% return.
When there is fear & sell off in stocks people run to the safety of US$ & Bonds.
@Gilbert: Fair enough, but what you describe is a short-term trade (a four-month holding period), not a long-term strategy.
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I have also been asking myself this question , but with emerging market bonds that are hedged to Canadian dolars.
What is your opinion about XEB from ishares for example? (http://ca.ishares.com/product_info/fund/overview/XEB.htm).
From what I understood from David Swensen’s book, he did not particularly recommend them, but then I read that Rob Arnott finds Emerging market bonds to be a good investment these days. I am still unsure if they would be a good fit in my portfolio.
Any thoughts on this topic?
Please include me in the draw. Thanks.
I sure could use the Turbo Tax.
Thanks for the opportunity.
@Philippe: The first thing to be aware of is that emerging market bonds are denominated in US dollars, not in their local currencies. And XEB (as well as BMO’s emerging markets bond ETF) hedge the currency. Which is good, since it makes little sense to get US dollar exposure when what you really want is exposure to emerging markets debt.
I put this asset class in the same category as high-yield corporate bonds: a reasonable holding for a small part of a portfolio, but certainly not essential. You mght be interested in Dan Hallett’s take on this:
Thanks for the opportunity to enter the draw for the TurboTax Premier Online. I really appreciate your blog too!
Count me in for the draw !
As to bonds, I’m still not entirely comfortable with bond funds, so I’m not going to consider going for US bonds. And given how currency hedging seems to be a major drag on returns, I’d tend to avoid it, though I don’t know if it’s a drag on bonds as much as on equities.
Thanks for the contest opportunity and it would be great to hear your thoughts on the new Pimco ETF in an upcoming post.
No comment on this blog but would love the Turbo Tax!
On another note, I just went all in on my own Couch Potato Strategy – finally took the plunge!
Thank you for your answer and providing the link to Dan Hallet’s article on emerging market bonds.
This new information has been very helpful in helping me to judge the suitability of emerging market bonds as an investment.
@Paul G: In theory, I would think that the drag from currency hedging should be the same in a fixed-income fund and an equity fund, but I was surprised to see that the two Canadian iShares ETFs that hold US corporate bonds with hedging (XIG and XHY) actually outperformed their US-listed counterparts in 2011, which is surprising. I’m going to look into the reasons why…
@JAH: I will give some thought to the new Pimco ETF and maybe do a post about it. Thanks for the suggestion.
@Dave: Congrats, and welcome to Spudsville!
@Philippe: You’re welcome, glad it helped.
@Paul G: Cozy up to bond funds. The savings (and potential for very easy diversification) therein are amazing!
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This is a US ETF for Canadian bonds (apparently, its one of a kind):
It seems like a good tool for re-balancing a portfolio while avoiding currency exchange fees (e.g., if you are overweighted in US equity ETFs).
I’d be interested in your thoughts on this fund.
Put me down for the draw. Keep up the great work. Thanks.
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Happy tax season! would love a chance to win turbotax premier!
I would like to be in the draw for turbotax.
As for US bonds i am a “couch” potatoe so i want to keep it simple. Adding more layers of investment at some point gets me back to where i was before i became a potatoe.
Turbotax software would be cool.
Thanks for clarifying the benefits of currency risk and hedging for stocks / bonds.
The interest risk is low in my view. Rates need to say low to keep the US treasury from imploding in debt costs, and the FED will continue to need to provide cheap liquidity. The FED has indicated low rates through 2014. Super-cycle analysis (read the Great Reflation by Tony Boeckh) indicates that the FED can and likely will also move lower for additional stimulus, especially considering the meager state of recovery.
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Interesting to note that Canadian Pension funds, as per the PIAC average pension asset allocation, have only a 1.76% allocation to foreign bonds. See: http://www.piacweb.org/publications/index.html?theyear=2010
Further, this is the highest allocation ever.
I do not expect to see a significant change in this allocation for the 2011 numbers (available April). (I know, because I have to fill out the darn survey …).
If investors are mirroring a pension plan as their personal investments guide, they need to accept that a foreign bond allocation is a tactical play … as Couch Potato points out and that ‘Gilbert’ provides a perfect example for.
For pension plans the purpose of bonds is to provide a liability match. Interest rate risk is assumed and accepted. Currency risk is not.
Regarding interest rate risk, well, both Governor Carney and the Fed’s Bernanke have indicated that interest rates will remain where they are thru 2012 and 2013.
@Doug: Many thanks for dropping by. This is well put: “For pension plans the purpose of bonds is to provide a liability match. Interest rate risk is assumed and accepted. Currency risk is not.”
Note to other readers: Doug’s blog does a great job of encouraging retail investors to use the same strategies that pension fund managers use. Check it out:
Thanks for the draw opportunity.
@CCP: Interesting post– I think we’re in agreement.
I prefer to keep the risk on the equity side of my portfolio– equities are well diversified using US domiciled Vanguard ETFs (VTI and VEU).
Fixed income I want to keep very boring– even with having roots in the U.S., I’m happy to keep my fixed income 100% Canadian. Safe and boring for this part of the portfolio is fine by me. Now if only I can beat inflation w/my fixed income!
I started my mutual fund couch potato a year ago after finishing university and starting my career. I have currently evened back out recently after about a 10% drop. Crazy how much I’ve learned about investing and even about myself as an investor from doing so. Still new at investing but it’s a start i guess. Thanks for the advice thus far and looking forward to more!
I’m not so convinced that currency hedging by the ETF holding Co’s is effective over the long term. This along with the significantly reduced impact of currency risk on a portfolio over long periods makes me much less hesitant to invest in foreign bonds. I don’t have any exposure now, but will be planning to add some down the road.
I hope I win the Tax program! ;)
Count me in on the TurboTax draw. Thanks.
Thanks for your time and information.
I am jumping onto the couch.
Any idea what kind of withholding taxes I can expect holding US or foreign bonds in an RRSP or TFSA? My understanding is that there is a “tax holiday” on US government bonds that is set to expire soon, would an RRSP be exempt from these taxes anyway?
@Owen: You should not expect withholding taxes on US bond interest at all: the 15% withholding tax imposed by the IRS applies only to dividends. However, I have heard some rumblings that it may eventually be extended to other types of income for US securities. If you’re planning to make a significant investment in US securities, I suggest consulting a tax specialist.
After reading the vanguard report it seems based all on what the us dollar has done and how it adds volatility compared to other currencies , I’m not sure it’s a good idea to say the same would hold true for the Canadian dollar. The Canadian dollar may move more in line with other foreign currencies and may not add more volatility as the report suggests is the case with the USD.
I am transferring my RRSPs to Questrade and switching over to $US. As part of my portfolio diversification, I was planning on including 3% of each Vanguard Total Bond Market ETF (BND) and Vanguard Total International Bond ETF (BNDX). After reading this posting, I am a bit unsure about whether this is such a good idea considering the currency risk. Should I be concerned with a small % of my portfolio in these funds with a plan for long-term investing?
As of Dec 31/12, the PIAC average asset allocation to foreign fixed income actually DROPPED to 1.5% (from 1.75% at year end 2011). http://www.piacweb.org/publications/index.html?theyear=2012
So much for the rush to foreign bonds.
Any chance you will revisit this topic? Specifically, what C$ ETFs are there for investing in US bonds that are not CAD hedged? From what I’ve read there are no new ones since your post above which is now more than 3 years old!
I feel like the last few years have shown that CAD-hedged ETFs in general end up increasing risk because they make Canadian investors even more overweight CAD then they are already from being overweight Canadian stocks!
@Aloke: The key ideas have not changed since this post was written. There is a new Horizons ETF that offers unhedged exposure to US bonds (ticker HTB) but this is not something I would recommend. I agree that Canadians should have exposure to foreign currencies, but this risk should be taken on the equity side, not the fixed income side. Hedging reduces volatility in bonds and increases it in equities. These may be of interest:
Thanks, HTB is exactly along the lines I was looking for, hopefully they will introduce something to mirror the broader US bond market.
I think the distinction you make between equities and FI is arbitrary. FI can certainly produce “equity-like” returns, look at the performance of IEF or TLT in the US over the last 10 years for an example. Currency exposure can add to or detract from those returns but investors should have the ability to choose those exposures. I don’t see why there should be a 20+ unhedged global equity ETFs and only a single unhedged global FI ETF.
Of note is that the PIAC composite for Canadian Pension Plans has about 1.19% Foreign Bonds. See
@Aloke & CPP: That HTB is also just what I’m looking for. I agree with The Spud’s view that due to currency fluctuations holding an unhedged US bond ETF is not a good strategy, however I’m likely moving to the US in 5 years so would benefit from holding a significant portion of my investments in US$. Thanks.
Great article! I have recently purchased ZIC which is unhedged. Given USD is going strong against CAD and will probably stay this way for some time, it is a good bond ETF to own now correct? If US interest rate goes up, will that affect the ZIC price negatively?
You state in that article that “[c]urrency 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.”
How much of this effect is negated with your new portfolios combining the international portion of equities into one fund? I imagine the impact on lowering volatility is greater when you break this portion of your portfolio apart (US, EAFE, EM).
Secondly, when slicing and dicing, what is the smallest % allocation there should be in a portfolio to have a meaningful impact. The old Uber-Tuber used to have 4% allocations. Does it make sense to go smaller?
@James: I’m not sure why using one fund instead of three would have any difference on the volatility of the overall portfolio. Your market exposure is almost identical in both cases, unless you rebalance the three-fund portfolio very frequently.
As for the benefit of small allocations, I think 4% to 5% is as low as it is ever worth going, unless a portfolio is very large. A 3% allocation in a $2 million portfolio is $60,000, which is not a trivial amount of money. But on a portfolio of $100,000 or so I’m not sure it even makes sense to go below 10% for any individual asset class unless there is no significant cost for doing so. (For example, I would not hold an individual emerging markets ETF in a very small portfolio, but I would use VXC or XAW, which have emerging markets built in.)