The Bank of Canada may have held the line on monetary policy on Tuesday, May 31, but the spectre of rising interest rates continues to hang over Canadian bond investors. Eventually, the Bank will make its move, wiping out billions in capital value.
Fixed income investors should look further afield to protect their portfolios, as global bonds offset some of the challenges facing the domestic debt market, according to a white paper released by Russell Investments.
“Canadian fixed income managers have learned a number of lessons in the aftermath of the financial crisis and some have implemented changes in their investment management practices,” writes Bilal Naqvi, senior research analyst at Russell. “One of the key lessons learned was to look at liquidity, credit and sovereign debt risks in a new dimension.”
Because Canada represents only 3% of the global investment grade bond market, employing a “domestic-only” fixed income strategy limits the liquidity of the portfolio. When the bond universe is expanded to sub-investment grade, the Canadian portion is even smaller.
A global bond portfolio is not only more diverse and more liquid, it can also be cheaper to implement.
“Bond trading costs generally decrease with credit quality and issue size among other factors,” Naqvi writes. “Canadian fixed income investors can optimize their portfolio in terms of improved trading costs and enhanced liquidity by selectively taking positions in significantly larger global bond markets.”
And much like the Canadian equity market, the domestic corporate bond market is dominated by a handful of key sectors, particularly financials. The increased breadth of the global market offers skilled managers the chance to generate alpha.
Also similar to the equity market is the home bias rationale that sticking to the domestic market reduces risk. But the Russell study found that on a credit risk basis, this argument simply doesn’t hold water.
“Some investors believe that owning non-Canadian bonds means taking on greater risk,” said Naqvi. “In fact, when we compared bond indices, we found that the key U.S. market benchmark, Barclays U.S. Aggregate, has a significantly higher percentage in the AAA bucket at 78%, compared to the Canadian index at 52%. So, investors who stay close to the Canadian index as a matter of risk avoidance do not necessarily have a credit quality advantage.”