Canadian bond inves-tors, exhausted by the past year’s lack of movement in domestic interest rates and the lack of bond price gains, have been migrating to global bonds, which have benefited from improving credit quality and surging liquidity in the world’s capital markets.

And in a sector in which portfolio managers get promoted or fired on the basis of performance measured in basis points, global bonds have been doing what amounts to pirouettes.

The past six months of global bond returns have been startling. The Citigroup world government bond index posted a gain of 8.07% for the six months ended Dec. 31, 2006. By comparison, Can-ada’s SC universe bond total return in-dex rose just 5.59% in the same period. The gain in global sovereign debt, in other words, was 44% more than the return on domestic, investment-grade Canadian bonds in the period.

For Canadian investors and advisors, picking this low-hanging fruit is not as easy as picking up a clutch of provincial bonds. Apart from Canada-issued bonds payable in foreign currencies, the global bond market is made up of unfamiliar names.

Entry into global bonds is much easier via exchange-traded funds. Like stocks, they are traded on equities markets. The majority of ETFs, which are closed-end funds, are priced on a combination of net asset value and investors’ evaluation of their future performance.

One can buy emerging-markets debt through Aberdeen Asia-Pacific Income Fund, with its current running yield of 6.8%, or Western Asset Emerging Markets Income Fund, with its running yield of 8.5%. Those yields are well above the 4.2% yield on the iShares broad market Canadian bond fund that emulates the SC universe bond total return index.

In global bonds — a sector made up of senior sovereign debt and sometimes dicey bonds from marginal countries — investors need to be sensitive to asset quality. Among funds known for keeping risk down is Pacific Investment Management Co. ’s Strategic Global Government Bond Fund, which is headed by widely respected manager Bill Gross. The fund’s running yield of 7% as of Jan. 31 is attractive.

Part of the reason global bonds and, especially, fresh issues of emerging-markets debt have done so well is technical. The flow of fresh, emerging-markets bonds being put on the market fell to 2.4% in 2006 from 22.7% in 2005, according to a Jan. 12 report in the Merrill Lynch Bond Index Almanac.

Rising demand and falling supply clearly have bullish implications for prices. What is more, the trend is toward quality. Europe continues to turn out most of the sovereign debt, while global corporate bond issuance rose by 10% in 2006. Over time, these trends imply rising quality and falling yields in global bonds.

So, is it time to buy into global bond funds? “There has been a very profound shift in the fundamentals of many emerging-markets countries,” says Richard Gluck, a principal and portfolio manager of global bonds atTrilogy Advisors LLC in New York.

“Many of these countries’ economies are far better managed than they used to be,” he notes. “There is opportunity to capture yield, but many managers have transitioned from debt denominated in U.S. dollars and euros to the currencies of the issuers. People are buying Brazilian and Colombian bonds in these countries’ currencies. The yields in these countries are good in relation to their inflation experience.”

Are closed-end funds the way to buy in? Canadian investors have access to portfolios listed on the New York Stock Exchangeand can trade in real time. In contrast, mutual funds are priced only at the end of trading sessions. But performance of Canadian-based emerging-markets mutual funds has been uneven, to say the least. For example, Templeton Global Bond Fund, the sector’s one-year winner, with a return of 13.4% for the 12 months ended Dec. 31, has a 10-year average annual compounded return of 2.4%, which happens to equal its management expense ratio.

As well, closed-end emerging-markets bond funds tend not to hedge their currency exposures. Foreign currency appreciation can add to underlying asset performance or cripple it — the risk goes hand in hand with the return. The top currencies for bonds in the sector are the US$, the euro, the yen, the pound sterling and the Canadian dollar. Issuers use G-7 currencies to reduce risk to inves-tors, after all. But close on the heels of the major currencies are the Indian rupee, the Polish zloty, the Mexican peso, the Turkish lira and the Czech koruna, most of which have gained in value and acceptance in recent years.

@page_break@Yet, there are credit risks to buying into countries with histories of defaults — common in South America, for example — and businesses that live or die on the fringes of world trade. A Standard & Poor’s Corp. survey of the debt of 113 sovereign issuers found that 69 had defaulted on their foreign-currency debt. The defaulters cover the globe from Argentina to Zimbabwe, but only eight of the deadbeats failed to pay bonds in their own — usually highly inflated — currencies.

“There is a lot of risk and not enough excess return over what developed markets bonds pay,” says Brad Bondy, director of research at Genus Capital Management Inc. in Vancouver. “What I have trouble with is that the outcome is dependent on random events, such as a leader in an emerging market deciding he won’t honour his country’s bonds.

“You have currency risk in the unhedged funds, as well as the difficulty of knowing the circumstances of the bonds in a fund,” he adds. “The plus side of foreign bond funds is that they do provide you with diversification.”

Bondy says that if your client wants to be in this market, you should advise him or her to buy a closed-end fund at a healthy discount for a measure of security, or go with a managed fund for the wisdom that the management fees are supposed to buy. IE