My Travel Notes On Canadian Bonds

by: Matt Tucker, CFA

This summer I am traveling around the globe, getting a closer look at foreign bond markets and what investors are doing in them. In my recent post I talked about the potential benefits of investing internationally. Today, I want to focus on Canada.

Similarly positive

Aside from being a close neighbor, with whom we share a lot in common, the Canadian bond market bears some resemblance to the U.S. market as well. The yield on the 10-year Canadian government bond is 1.07%, not far below that of the 10-year U.S. Treasury at 1.55%, as Bloomberg data shows. This is quite a difference from many other sovereign markets, many of which are involved in stimulus policies that push down interest rates. In fact, as of June 30 over 40% of developed market bonds had a negative yield according to Bloomberg data. 40%!

Looking at the central banks we again see similarities. The Bank of Canada (BOC) has set its short-term interest rates at 0.50%, just above the U.S. rate of 0.25-0.50%. Given that the United States is Canada's largest export market and the two economies are inextricably linked, there are expectations that should the Federal Reserve raise short-term rates later this year, the BOC may follow as it has done in the past.

A mixed story

Canada and the United States are alike in more ways than one, but should U.S. investors consider the Canadian bond market as an investment destination? The Canadian market has offered positive yields, according to Bloomberg data. And the economy's growth has been positive: 1% in 2015 and 1.3% (forecast) in 2016, according to BOC data. But the investment case for Canada is a mixed story at best.

To begin with, the yields in Canada have been lower than those of the United States (illustrated in the chart above), and if you invest directly in the Canadian bond market, you will be faced with currency risk. Movements in the exchange rate between the Canadian dollar and U.S. dollar could easily overwhelm the yield on a bond investment. And, the Canadian bond market is much smaller than the U.S. bond market, so there are not as many opportunities for investment. The government and investment grade markets are fairly well developed but much smaller in size: $1.2 trillion for Canada versus $18.8 trillion for the United States (Source: Barclays).

And there are fewer offerings. Higher yielding segments of the U.S. dollar bond market, including high yield, emerging markets and mortgages, are not as well developed in Canada.

A useful diversifier

All in all, Canada just doesn't present a significant value proposition for U.S. bond investors right now. Potentially, Canadian bonds could be interesting as a diversification play as part of a larger global bond portfolio. But this of course means that you would have to like some of the other countries as well. More on that next time as my tour moves onto Europe.

This post originally appeared on the BlackRock blog.