The removal of for-eign-content restrictions on Canadian registered plans such as RRSPs and RRIFs in early 2005 has stimulated a rising tide of interest in foreign fixed-income investments. Although Canadian investors have traditionally considered their foreign-content allowance a place to hold international equities, with the restrictions gone they are finding a place for both stocks and bonds issued around the world.

“It used to be that the 30% foreign-content allowance was sacred. And if people used it, they put assets into stocks and didn’t waste time and space on foreign bond markets,” says Andrew Pyle, vice president and senior financial markets economist at Bank of Nova Scotia. “Since the rules were relaxed, there has been a lot more demand for foreign bond products, from both institutions and individuals. People can now put money into foreign bonds without chewing into their foreign equity allocations.”

Recent numbers from Statistics Canada confirm the trend. For the six months ended June 30, net Canadian investment in foreign bonds totalled $23 billion, almost double the $11.9 billion for the same period in 2005, and almost four times the $5.7 billion invested in the first half of 2004. “Since the restriction was removed, investment in foreign bonds has virtually doubled in each of the past two years,” says Pyle.

Rising demand comes despite skimpy international bond returns in the past few years, largely because of the corrosive effects of the strengthening Canadian dollar. Only three of 36 foreign bond funds tracked by Morningstar Canada had positive returns for the three years ended July 31: Friedberg Commodity Management Inc. ’s Friedberg Foreign Bond Fund, with an average annual return of 8.3%; RBC Asset Management Inc. ’s RBC Global Bond Fund, with 2.8%; and BMO Investment Inc. ’s BMO World Bond Fund, with 1.5%.

“Diversification is the only free lunch when it comes to investing,” says Michael Hart, head bond trader at Friedberg in Toronto. “A lot of bond fund managers don’t want to stand out and hug the middle of the road by staying close to the benchmark indices. We outperformed for the past five years by having our biggest positions in inflation-protected securities such as real-return bonds that offered a superior yield to regular bonds.”

Scott Lamont, director and head of fixed-income at Phillips Hager & North Investment Management Ltd. in Vancouver, says a portion of bonds offers good diversification and “efficient frontier” characteristics in balanced portfolios, but his firm uses global bonds “opportunistically” rather than having a rigid allocation target. Because currency exchange rates pose a risk in investing in foreign securities, his firm usually employs hedging strategies. PH&N will only invest in foreign bonds when the positive yield differential outweighs the cost of hedging.

“Currently, there is a meaningful yield advantage in U.S. bonds relative to Canadian, and the spread is higher across the yield curve than it’s been in decades,” Lamont says. “You can pick up a fair bit of yield advantage on some foreign bonds, but our tendency is to hedge the currency unless there is a good case not to.”

As an example of the yield differentials, in mid-August a 10-year Government of Canada bond had a yield of 4.36%, compared with 4.96% on a comparable U.S. bond and 5.85% on an Australian bond.

“Global economies and interest rate cycles are not perfectly synchronized around the world, and that creates opportunities for investors,” says Liz Lunney, senior vice president in Toronto at Fiduciary Trust Co. of Canada, a division of Toronto-based Franklin Templeton Investments Corp. “There are opportunities to access higher rates outside the country. There can also be times when rates are flat or increasing in Canada while declining in other countries, creating better opportunities for capital gains in bonds.”

When interest rates decline, the value of bonds issued previously at higher rates will increase because of their relative attractiveness to the new bonds being issued. Pyle says the interest rate cycle must be assessed carefully, and although rates are levelling off in North America, there could be further increases in other countries such as Japan, with potential negative effects on the value of outstanding Japanese bonds.

Lunney says that because of the rising C$ and the cost of hedging, Franklin Templeton has held the foreign bond component in its Quotential Diversified Income Portfolios to the minimum end of the allowable 20%-30% range, placing a higher emphasis on Canadian bonds, income trusts and dividend-paying stocks.

@page_break@But, she adds, there will be a point at which the outlook for further increases in the C$ will be dim, and for long-term investors it makes sense to diversify out of the home market, which accounts for less than 3% of global fixed-income assets. IE