The hidden value of global bonds

With nearly CAD$10 trillion in global bonds trading with negative yields, why would anyone in their right mind consider them in a portfolio? For the same reason any investor seeks diversification in portfolios: to improve risk-adjusted return through return enhancement, risk reduction, or some combination of the two.

And while the risk reduction component is relatively straightforward, the return opportunity may not seem compelling at first glance. Many investors don’t consider the beneficial impact of additional yield, or “carry,” that can be generated from hedging foreign currency denominated bonds. Hedging can help augment the paltry yields offered in some of these low yielding bond markets.

Consider markets like Germany or Japan that offer investors little in the way of return, with stated short and medium term bond yields that are negative. The return opportunity may seem unattractive in such markets, but a Canadian investor can hedge out the currency risk to earn a positive carry, or return, on Euros or Japanese Yen, respectively. Table 1 is a recent illustration of what an investor can earn by hedging foreign currency (positive values indicate positive “carry,” or return) from the standpoint of a Canadian investor. Table 2 shows the net effective of FX yield plus the local bond yield.

Risk benefit

The risk reduction argument is more straightforward. Adding foreign bonds to a portfolio (and hedging the currency) allows investors to diversify risks related to economic growth, inflation, monetary or fiscal policy and so on, as opposed to being fully exposed to these domestic risks.

The chart below highlights a BCA study** showing how investors with different base currencies fared by investing in foreign bond markets on a hedged and unhedged basis. The message is clear: for Canadian investors, hedged foreign bond returns have effectively been the same as local bond market returns, but diversifying exposure across multiple foreign bond markets contributes to a lower overall risk profile than holding only Canadian bonds. In fact, Canadian bonds were substantially riskier during this period.

Conclusion and Positioning

Given our view that global growth will remain above trend and inflation will move higher, our portfolios remain underweight bonds overall. These factors should keep pressure on yields to continue moving up, a headwind for developed-market government bonds in general. However, while the return outlook for most government bond markets is unattractive in the medium term, these markets are essential portfolio diversifiers.

Within the developed-market government bonds we do hold, we are enhancing our diversification in foreign government bonds. In the Canadian bond market, we see the risks of better economic fundamentals, tighter output gaps and recovering inflation that could spur the Bank of Canada to continue on its path to normalize interest rates. Furthermore, the current superior hedged yields in many foreign bond markets (from a Canadian dollar perspective) is another reason to look to diversify abroad.

Franklin Templeton Investments Canada is a business name used by Franklin Templeton Investments Corp.

Stephen Lingard’s comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.

Important Legal Information

All investments involve risks, including the possible loss of principal. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in emerging markets, of which frontier markets are a subset, involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Because these frameworks are typically even less developed in frontier markets, as well as various factors including the increased potential for extreme price volatility, illiquidity, trade barriers and exchange controls, the risks associated with emerging markets are magnified in frontier markets. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions.