Canada's bond market: Too insular for its own good

Small, underdiversified and potentially overpriced - that's our Canadian bond market.

Hey, you could say the same thing about Canada's stock market. What to do about it? In both cases, global diversification makes sense right now.

Most investors are familiar with the benefits of owning global equity funds, exchange-traded funds or individual stocks, but global bonds are comparatively obscure. New research from Russell Investments Canada provides some very solid reasons to address this imbalance in your own portfolio.

First off, there's the lack of diversification in the Canadian bond market, which again parallels the stock market. While resource stocks dominate the S&P/TSX composite index, government bonds account for most of DEX Universe Bond Index, Canada's benchmark for bonds.

"Over 73 per cent of bond issuance in Canada comes from government - that includes federal government, the provinces, government agencies and municipalities," said the report's author, Russell senior research analyst Bilal Naqvi. Arguably, this makes Canada's bond market too conservative.

Because they're the ultimate in safety, government bonds pay lower interest rates than corporate bonds. The net result for investors is a lower-yielding bond market than elsewhere in the world. Take the United States, for example. Mr. Naqvi's report says government bonds account for 41 per cent of the bond market there. In the global bond market, government-issued debt accounts for 60 per cent of the total.

Not only is Canada's corporate bond market small, but it's also 52-per-cent weighted to the financial sector. Don't overestimate the safety of a high weighting in financial companies. The Russell report notes how some Canadian bond fund managers have seen their returns suffer as a result of a downgrade of Manulife Financial bonds that occurred because of fallout from the financial crisis.

While the Canadian stock market accounts for about 5 per cent of total global equities, our bond market comes in around 3 per cent of the worldwide total. Both markets have punched well above their weight lately. Just as a heavy weighting in resource stocks has helped propel the Canadian stock market in the past few years, the country's strong financial foundation has pulled money into the bond market.

Mr. Naqvi found that bonds issued by Canadian companies trade at higher prices than those of comparable global companies with the same credit ratings. Yields move in the opposite direction as prices, so this hasn't been good news for people who need the income that bonds generate.

The Canadian stock market has underperformed global markets this year because of weakness in resource stocks. Greg Nott, a fixed-income portfolio manager at Russell Canada, said the bond market may be next to fall behind. His rationale starts with an expectation that the Bank of Canada will be more aggressive than other central banks, notably the U.S. Federal Reserve Board, in raising interest rates in the months ahead.

"That could put some upward pressure on bond yields here in Canada, and that would potentially cause the Canadian bond market to underperform global peers," Mr. Nott said. "We've seen that happen in the past few months, where U.S. Treasury bonds have outperformed Government of Canada bonds."

Canada's bond market is safe - that's a big reason why it has performed well in recent years. But is it safer than other bond markets around the world? "The Canadian market does not have any advantage in terms of superior credit quality," Mr. Naqvi wrote in his report.

A snapshot view on this: The DEX Universe Bond Index, Canada's benchmark, is 52-per-cent weighted to bonds with a sterling triple-A credit rating, while a comparable U.S. index is 78-per-cent made up of triple-A bonds. The global bond market's weighting to triple-A bonds, meanwhile, is similar to Canada's.

As for the risk of default, the report shows that Canada is at much the same level as both the United States and the rest of the world. Obviously, the countries in Europe that are struggling to manage their debt loads would be an exception.

Mr. Nott divides institutional bond fund managers into two groups: those who build portfolios that look similar to the DEX universe index and those who go beyond this Canada-only benchmark. In that latter group, you'll typically find 10 to 40 per cent of a bond portfolio invested outside Canada. High-yield bonds might be part of the mix, as well as emerging-markets bonds.

Mr. Nott has two pieces of advice for investors who want to add global bonds to their holdings, the first being to use a fund approach rather than trying to buy individual bonds. "It's very difficult for an investor or an adviser to access some of these [global]market segments, and that's why we would typically recommend a fund solution," he said. "That's how you get the access and the diversification."

His other piece of advice is to choose funds that use currency hedging, which is a somewhat controversial position. After a multiyear rally, some would say there's more long-term downside to the Canadian buck than upside. That would favour an unhedged approach, where a falling dollar would add to gains in assets priced in foreign currencies.

Mr. Nott said global exposure might conceivably add one percentage point to the returns of a bond portfolio. But volatility caused by exposure to foreign currencies could cause the value of the fund to easily swing up or down by something like three to five or even 10 percentage points.

It's worth noting that global bond funds were among the strongest performers of any fund category in the difficult days of 2008. This was partly because investors all over the world craved the safety of government bonds, but also because the Canadian dollar fell. The average global bond fund that year made 19.1 per cent, while the average Canadian bond fund made 2.8 per cent.

Canadians are known to have a strong preference for investing at home, but the tendency is particularly notable with bonds as opposed to stocks. Data from the Investment Funds Institute of Canada show that global bond funds represent about 18 per cent of total assets in bond funds, while global and international equity funds account for a bit over one-third of equity fund assets.

Mr. Nott notices that institutional investors have been increasing their holdings of global bonds lately. "We expect to see that carry over to the retail side as well, probably with a bit of a lag."

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Two tips for global bond investing from the experts at Russell Investments Canada

1. Buy funds instead of individual bonds for greater diversification and access to bonds retail investors may not be able to find on their own.

Mutual Fund Options (five largest funds)

Exchange-Traded Funds (a sampling of diversified global bond ETFs)

2. Buy funds that use currency hedging to limit the effects of fluctuations in the Canadian dollar.

The ETFs mentioned above are U.S.-listed, so they do not hedge returns back to Canadian dollars. Here's how the mutual funds listed above handle hedging:

Notes:

Mutual fund returns are in Canadian dollars.

ETFs returns are in U.S. dollars.

All returns are to April 30.

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Terry Carr, manager of the Manulife Corporate Bond Fund, takes your questions in this live one-hour discussion Friday, May 27 at 11 AM ET. Mr. Carr's $838-million fund, which is split between investment grade corporate bonds and wilder high-yield issues from Canada, the United States and elsewhere, is top-ranked by Lipper.

It has returned 8.3 per cent over the past 12 months, and in 2009, it returned an amazing 25.2 per cent. And when the stock market was melting down in 2008, cutting major indexes in half, the fund turned in a comparatively slim loss of just 8.3 per cent. (Read more about Mr. Carr here )

Mr. Carr will share his strategy on making big - yet relatively safe - returns from the bond market and provide insight on how your portfolio could benefit.

Readers using mobile phones should read the discussion by following this link.