Q: I was surprised to see a Vanguard infographic pointing out that international [non-US] 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 unwise. 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 US 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.
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:
| Canadian | Global | |
|---|---|---|
| 1 year | 5.80 | 5.95 |
| 2 year | 4.33 | 5.07 |
| 3 year | 5.19 | 5.11 |
| 10 year | 5.52 | 4.89 |
| Since February 1999 | 5.73 | 5.18 |
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 might be 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 might make sense to divide that among Canadian, US and international bonds to reduce your risk.
@JWW: HTB does not hedge currency, so I would not recommend it unless you specifically needed exposure to the USD dollar in your fixed income (for example, if you happen to have future obligations in USD). The problem is, if all of your holdings need to be in taxable accounts then your options are very limited, because the only global bond index ETF that hedges to CAD is VBG, and it is not tax-efficient. With that in mind I would say any diversification benefit from global bonds would be outweighed by the tax disadvantage.
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What about for someone who is planning on either retiring or spending half time overseas. If you knew that you had a specific country in mind you could buy bond etf hedged to their currency? If you didnt have a specific location but knew it wasnt Canada, is this a case where unhedged global bond fund would make sense? Holding 50% of portfolio in Cdn bond etf if a significant portion of retirement expenditures will be non-cdn seems like a really big bet on Cdn dollar?
@meera: In theory, yes, it makes sense to hold a portion of your assets (maybe a large portion) in the currency where you expect to have your future liabilities. In practice, though, I am not sure how one would set this up unless the foreign country was the US. It is not possible to get any meaningful exposure to other foreign currencies using fixed income ETFs in Canada.
@ccp
Thanks for your reply! What if one were to buy something like vanguards new etf VETY on LSE? As a canadian am i eligible to buy these etfs? I think TD DI lets me trade on LSE but have nevee tried
@meera: I believe that TD and a few other brokerages (such as HSBC) do allow you to trade on foreign stock exchanges, but be aware that the fees and commissions are likely to be quite high.
Similar to the question I’ve asked before (on a different) regarding USD income and choosing USD index-equity funds, what’s your take on buying bonds outside the Canadian market?
If I have access to USD, and now isn’t a particularly great time (compared to a year ago) to convert to CAD, would it make sense to buy some BND and BNDX?
@calyth: I do not recommend taking current risk in fixed income. If you have USD, it is generally preferable to use it to buy US and international equity ETFs and to keep your fixed income in CAD.
https://canadiancouchpotato.com/2012/03/01/ask-the-spud-should-i-hold-us-bonds/
Hi, Dan. I’m looking at putting a portion of my bond exposure in VBU. However, the stats on Vanguard’s website are confusing. The yield on VBU is 1.81% (apparently calculated on the last distribution), much lower than the average coupon at 3%. How could it be so much lower? Is there a hidden hedging cost embedded somewhere not included in the MER?
@Greg: This is the case with almost all bond funds: i.e. the coupon is higher than the yield to maturity. This is because these funds are filled with “premium bonds” that were issued when rates were higher than they are today. That’s the main reason traditional bond ETFs are so tax-inefficient. This is a pretty complex topic, but this might help:
https://canadiancouchpotato.com/2013/03/06/why-gics-beat-bond-etfs-in-taxable-accounts/
@ Dan: Thanks for the reply, Dan. However, I’m talking about the distribution yield of 1.81%, not YTM. Shouldn’t this be closer to the average coupon of 3%?
@Greg: Sorry for the misunderstanding. You’re right, these numbers should be closer. My guess is that it’s just a temporary anomaly in the reporting, perhaps because a recent distribution was smaller than the average. The cost of hedging is trivial and would not affect this. In any case, assuming you are holding this in a registered account, the YTM is the only number that really matters.
@Dan:. Yes, YTM is most important. Thanks!
Hi,
Since in the next 10-15 years I will use my bonds to rebalance my portfolio and not to provide income, wouldn’t US Bonds lower my currency risk? A large part of my equity allocation is in USD. For example, if CAD losses more ground to USD and at the same time there is a market crash, I would prefer to have US bonds to rebalance rather than canadian bonds.
@Julien: The problem is that by adding currency risk to your bonds you lose much of the stability that fixed income is supposed to offer. If there is a market crash, you could see both your equities and your bonds falling sharply in value. Currency risk can lower volatility in a portfolio, but it should be taken on the equity side.
Hi, do you know any Canadian online trading site that lets you buy international bonds (specifically looking at Argentina bonds) directly without making a phone call?
First of all, I just wanted to say thank you to Dan for all your work in creating and managing this blog. I learned a lot from this blog about the passive investment strategy.
As a follow up to Greg’s question, I find it interesting that VBU and BND have significant differences in total returns even though they both hold the same US bonds.
As per Morningstar,
Total Return %
3-Year VBU (NAV) 1.29%
3-Year BND (NAV) 2.88%
And taken from factsheet from Vanguard websites,
Factsheet | April 30, 2019
3 year VBU Net asset value (NAV) total return 1.10%
Factsheet | March 31, 2019
3 year BND Net asset value (NAV) total return 2.00 %
Dan, you mentioned that the costs of hedging would be trivial. What could explain the gap between VBU and BND total returns?
And with this significant tracking error, is it worth holding VBU in the portfolio (as is the case in the Vanguard all-in-one portfolio VCNS/VBAL/VGRO)?
@David: Excellent question that Justin answers in detail here:
https://www.canadianportfoliomanagerblog.com/giving-currency-to-currency-hedged-global-bond-etfs/
CAD-hedged ETFs have considerable higher MER than the same US based.
I’m wondering if you can update this article for 2020. As a Canadian, is holding a US treasury bond in a taxable account still not worth the trouble?
Have more options arisen?
Given current economic outlook??
@Karen: In my view, holding USD-denominated bonds without currency hedging is inappropriate for the vast majority of Canadian investors. USD exposure is better obtained through US stocks.
That said, it is now easier to buy global bonds with currency hedging if this is something you want. For example, Vanguard recently launched VGAB, a fund that holds both US and international bonds in a single fund.
So Dan is there *any* reason why might an investor benefit from some foreign bond exposure? Even if they have a more modest portfolio? There is some in XBAL after all, about 7% in USIG and GOVT.
Seems that diversifying is always a good bet to a passive/index type investor and I’ve always taken that as “gospel”.
Thanks for writing this article! I’ve been looking into whether to own foreign bond ETFs.
@Jim: Thanks for the comment. If adding foreign bonds is no additional work (such as if you’re using an asset allocation ETF), then I think they are just fine. However, I don’t think it is necessary for the vast majority of investors to hold individual ETFs of foreign bonds.