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 [email protected] 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.
@Dan,
Thank you for the reply. To the first part of the discussion, I guess my understanding of the benefit of multiple currencies came with annual re-balancing which is partially lost when you package funds together like in VXC. But your market exporsure would be similar. Although wouldn’t using a fund like VXC mean that the US and International allocations would float against each other vs if you split them out, you would control and re-balance back to the desired allocations of each and thus reducing volatility?
As for the second part of your answer, thank you. I will keep that 3% example for when I get there.
@James: In theory it’s true that there might be “rebalancing bonus” to splitting the three asset classes in a fund like VXC, but in practice I expect this is likely to be very small. Justin looked at a related idea in his latest blog:
http://www.canadianportfoliomanagerblog.com/split-the-eafe-for-better-returns/
How about for us US/Canadian citizens? The IRS deeply incentivizes you against foreign ETFs. Is there a NYSE-traded product that tracks Canadian bonds?
@Jordan: I’m not aware of any US-listed product that tracks Canadian bonds. For US citizens living in Canada there are a few options for fixed income: hold Canadian bond ETFs in your RRSP, or in a taxable account you can hold individual Canadian bonds (e.g. a 10-year ladder) or use GICs.
NEI Global Total Return Bond Series F (NWT595) is a mutual fund that holds United States Treasury Notes and bonds and is hedged to the Canadian dollar.
I’ve been looking at this lately. After record returns in stock indices and long term bonds downtrend since the covid crash, I feel like it might be worthwhile to add some here to protect against potential market hiccups.
BMO has ZTL, and ZTL.F is the currency hedged version. I think it’s a good safe haven to add to diversify my portfolio. I’m just not 100% sure about the currency hedging part. My opinion in short: use the currency hedged one if you plan to add as a long term holding. In my case, I’ll rather be using as a short term “swing” experiment and will sell if the markets dips (to re-position capital in stocks).
Hi Dan,
Do you have any discussions on why an investor would choose to allocate some of the fixed income of their portfolio to corporate bonds rather than/in addition to the normal bond index funds/ETFs?
Namely, I am wondering if this would make a significant difference both in terms of making the returns less volatile and perhaps also increasing the returns generated by the fixed income portion without adding volatility. Does this make sense in a smaller (< 50k) portfolio?
@Louca: Traditional bond index funds include corporate bonds (usually 20% to 30%). Corporate bonds are likely to make your portfolio more volatile, not less. For a portfolio under $50K I would almost always recommend an asset allocation ETF, which will have mix of government and corporate bonds. No need to make things more complicated than that.
Can a Canadian buy a US I bond ?