Global bond diversification: should we?

Global bond diversification: Should we?
Adding global bonds to your portfolio is an important decision
By Mark Watts, Head of North American Fixed Income, Baring Asset Management

The investment landscape in Canada has changed a great deal over the last decade and will continue to do so. Change brings with it opportunity.

Recent changes to legislation have allowed Canadians to invest more overseas; currently the overseas exposure has a 30% maximum limit. The typical plan sponsor took the opportunity to invest overseas by buying equities, but what may make sense for a 20% allocation may not be so prudent for a 30% allocation.

Should bond exposure be added? To answer this question we must look at the past and make assumptions about the future. Over the last 10 years it is true that overseas bonds marginally underperformed domestic bonds with higher volatility. This is not the whole picture. Examining correlations shows us that overseas bonds offer excellent diversification benefits (almost zero versus domestic bonds and negative versus the Toronto Stock Exchange [TSE] 300 index).

Putting the two together, we can construct an efficient combination of assets that allows a portfolio to be constructed that increases return and decreases risk when compared to a domestic-only portfolio. The way that we look at efficient mixes of assets is by examining their historical return and risk attributes and the extent to which the asset classes are correlated.

In the chart below we have plotted a few mixes of asset classes based on analysis of 10-year historical data. Point A represents a 60% equity/40% bond portfolio of Canadian-only assets (here we have used the TSE 300 for equities and the Scotia Capital Markets Universe for bonds). The series of diamonds represents the risk/return profile of overseas assets ranging from 100% invested in global bonds (SWGBI) to 100% invested in global equities (MSCI) - with 10% increments in between. Point B is a point on the efficient frontier that looks very attractive from a domestic Canadian standpoint - much higher return with slightly reduced risk.

By combining 70% point A and 30% point B we construct a portfolio with the attributes of point C.

It can be clearly seen that by adding 30% overseas assets (comprising 70% equities/30% bonds) we can add return and reduce risk, a far more efficient mix of assets. Adding global bonds does have benefits to a Canadian investor.

Will this continue? Yes, if you think past themes will be repeated. The relationship may even look better in the future if the Canadian dollar continues to fall, correlations remain low and the U.S. dollar is not the strongest currency in the world.

Contex Group