Ins and Outs of International Bonds

Bonds don't exist only in Canada. The world bond market is vast - at least as large as the equity market.

Why buy foreign bonds

• Diversification - just as foreign equities move up and down in different patterns than Canadian markets, so do foreign bonds. This non-correlation will dampen volatility when incorporated in a portfolio. Roger Gibson describes the effect in his classic book Asset Allocation. The Google Finance chart below shows how differently an international bond fund (NYSE symbol: BWX) behaved during the 2008 market meltdown compared to both the TSX composite equity index and a Canadian index bond fund (TSX symbol: XBB). If one were to factor in the big drop in the Canadian dollar vs the US dollar that occurred (since BWX is sold on a US exchange and denominated in USD) during late 2008, then the beneficial effect for a Canadian holding BWX would be even more pronounced.

• Inflation hedge - the study Can Canadian Investors Still Benefit from International Diversification: A Recent Empirical Test from Simon Fraser University modeled international bonds within a portfolio during 1996-2006 and found that they provided inflation protection to Canadian investors
• Income - like any other bond, international bonds generate interest income at rates that are likely to be comparable to Canadian bonds of similar quality - XBB's average coupon is currently 5.29% and yields 3.25%, while BWX's coupon average is 4.32% and yields 3.85%

Risk factors and other considerations

• Credit/default risk - the chance the issuer won't pay back the principal as promised; may not be a big factor as some funds hold only developed country government bonds - will the UK, Japan or France likely default? Check the fund holdings and its investment policy. Individual bond risks are always minimized by buying a fund rather than an individual government or company bond.
• Interest rate risk - if rates suddenly move up in a country, bond values will go down. Movements tend to average out over many countries.
  
• Liquidity risk - an individual bond may be hard to sell and if so, a seller will get a lower price
• Currency risk - a key factor, as exchange rate shifts usually far outweigh any other factor. Some funds eliminate this factor by hedging, which adds cost of course. In the long term and over many countries, many but not all, researchers say the currency swings cancel out. In the short term, the swings can provide the basis for the portfolio-rebalancing strategy of buying low and selling high (see renowned Yale University Chief Investment Officer David Swensen's explanation here)
• Costs and Expense Ratios - transaction commissions for discount brokerage customers appear in the form of the buy-sell spread, the difference between the price the broker will buy from you or sell to you; the greater the spread, the costlier this is, though if you hold a bond to maturity, the cost as averaged over many years can be small i.e. constant buying and selling of individual bonds will cost a lot and eat up much of your returns. Expense ratios (MERs) are published for funds and the basic principle is, the lower the better.

What is available to buy

• Individual Bonds - there is excellent choice of bonds of US issuers, sold in USD through the same web online self-serve menus as individual Canadian bonds.
• Global / International Bond Mutual Funds - sold by Canadian mutual fund companies, there is a choice of about 80 funds listed on GlobeFund with MERs ranging from 0.16% up to 3.04%. Most are actively managed and many of the lowest MER funds (1% or less) have a very high minimum initial investment like $100,000 or they are sold only through financial advisers, not directly to DIY investors.
  
• ETFs - unfortunately, there are no international bond ETFs available from Canadian providers. Thankfully, there is a big choice of ETFs sold on US markets (Stock Encyclopedia lists most of them here)- 1) US-bond only funds e.g. the biggest whole-of-market funds are AGG and BND, 2) Emerging Market (higher yield and higher risk) like EMB and PCY; 3) Developed Country funds that exclude the USA like IGOV and ISHG and: 4) Whole of World funds that include Canada, the USA and emerging countries like BWX and BWZ (see IndexUniverse's International Bond ETFs Compared). As is typical of most ETFs, most of these funds have low MERs (0.50% or lower) due to passive tracking of an index. Most are also not hedged and most of the bonds within are government bonds. Note that despite being denominated in USD, the unhedged international funds' currency risk is NOT the USD vs CAD shift but that of the origin country currencies combined as CanadianFinancialDIY explains in Clarification of Foreign Exchange Risk on International ETFs.
  

In today's global village, a savvy investor should not shy away from foreign bonds merely because they come from elsewhere. There's a whole wide world out there.

Disclaimer: This is presented as an investing idea, not as advice. Whether you take up the opportunity is always up to you the DIY investor.