Pension funds in Canada have long relied on a simple fixed-income strategy: buy Canadian. And for a long time, this worked wonders. But times are changing, and our research suggests that swapping a Canada-only approach for a more globalized portfolio will provide better risk-adjusted returns in the future.
The old Canada-only allocation was a winner when Canadian bond yields were in a multi-decade decline. But in 2013, as interest rates began to rise from near-record lows, Canadian bond returns were negative for the first time in 14 years.
They retraced some of their losses last year as interest rates declined, but we expect rates to resume their climb in the years ahead. In such an environment, domestic bonds won’t be able to deliver the kind of returns that pension fund managers have grown accustomed to.
None of this means that Canadian pension fund managers or other investors should abandon bonds, which remain useful diversifiers against riskier equities. But they’re going to have to find ways to make their bonds work harder. We think that the best way to do this is to go global.
A Bigger Pond to Fish In
To start with, a global approach provides fund managers with a bigger pond to fish in. At the end of 2014, the Canadian dollar–denominated portion of the Barclays Global Aggregate Bond Index comprised about C$1.7 trillion in outstanding debt, and about 90 investment-grade corporate bond issuers.
The US and European components of the index boasted about C$19 trillion and C$17 trillion in outstanding debt, respectively, with more than 1,000 corporate bond issuers between them. That’s more than a 20-fold increase in investment options—and doesn’t include an additional C$11 trillion in outstanding debt issued in Asia, Latin America, Africa and the Middle East.
Globalizing Diversifies Interest-Rate Risk
Going global also allows diversification of interest-rate and economic risk—an important attribute at a time when business cycles, national growth rates, monetary policies and yield curves around the world are headed in different directions.
Today’s headlines prove the point: while official rates in the United States appear to be headed higher, the opposite is true in Europe, Japan and certain emerging-market economies, where weakening growth is prompting central banks to add stimulus. In fact, year to date, more than 20 central banks—including Canada’s—have eased their monetary policy, and several have embarked on some form of quantitative easing. By embracing a global approach, pension funds can reduce their portfolios’ sensitivity to the rate cycle of their home market.
It follows, then, that the returns—and risks—associated with various countries can be very different than those associated with domestic assets. A historical dispersion of returns among currency-hedged developed-country sovereign bonds shows that Canadian bonds were at or near the top of the heap between 2005 and 2008. But in 2012, they were dead last, underperforming euro-area government debt by almost 10%.
In fact, the typical return gap between the best- and worst-performing markets is 5% or more. Such large gaps offer investors the potential to boost returns and add value by actively managing country exposures.
Better Potential Risk-Adjusted Returns
In our view, these are strong reasons to consider a more global allocation. But they aren’t the only arguments. Our research also suggests that global bonds offer comparable returns to domestic bonds, with less volatility.
Between 2001 and 2014, the average annualized return on a portfolio of currency-hedged global bonds was 5.0%, compared with a return of 5.2% for an all-Canada allocation. But the volatility of the global portfolio was 2.1%, compared with 2.5% for the Canadian portfolio, resulting in a risk/return ratio of 2.3 for global bonds compared with a risk/return ratio of 2.1 for Canadian bonds.
Taking Currency Out of the Equation
But here’s the thing: the portfolio’s non-Canadian currency risk must be hedged out. Investors sometimes assume that currency exposure will boost returns over the long run and reduce overall risk. But our research suggests that that isn’t the case. When we compared the three-year rolling standard deviation of three types of bond portfolios over the past 12 years, we found that the hedged portfolio was less volatile than both the unhedged one and the Canada-only one (Display).
Hedging is especially beneficial for Canadian investors. Because Canadian cash rates are higher than those in many other countries, investors will gain yield if they hedge out their exposure to lower-yielding foreign currencies.
Altering a tried-and-true formula can be difficult. But when economic and financial-market conditions change, investment strategies should change with them. By adding global bonds, Canadian investors are more likely to reduce downside risk while capturing nearly all of the upside potential of a purely domestic portfolio. That should leave plans in a better position to meet tomorrow’s retiree-benefit obligations.