There’s a groundswell of enthusiasm for investing in global assets in the wake of Finance Minister Ralph Goodale’s Feb. 23 budget speech promising to eliminate the 30% foreign content limit on RRSPs. Too bad the cheering is for the wrong thing.

Clone funds already make it possible to hold RRSP portfolios filled with nothing but foreign stocks and bonds with a fee surcharge of 50 basis points or more for the costs and complexity of the effort.
Double-digit foreign stock returns could accommodate the extra fees, but single-digit bond returns could not. Now that the cap is off foreign content, global bonds make more sense.

The argument in favour of just letting investors have their fill of foreign stocks is outdated; it rests on the observation that Canada amounts to only 3% of world stock market capitalization. To get more exposure to global capital markets, the investor needs some foreign stocks, argue those making a case for international equities. But the pitch turns out to be of little relevance.

Mature world stock markets move in directional synch, the result of global economic integration. In 2004, for example, the S&P/TSX composite total return index was up 10.9%. In the same period, the Morgan Stanley Capital International EAFE Index in Canadian dollar terms was up 12.4%, MSCI Far East in C$ was up 8.2%, MSCI Japan in C$ was up 7.5%, and MSCI Latin America in C$ was up 29.5%. In retrospect, a clutch of Latin stocks was the best to have, but in directional terms the markets moved together. The investor or advisor who wants to reduce risk would have had trouble in world equities because they were moving as one, although clearly not quite to the same beat.

Where the new freedom to hold foreign assets will be of the greatest help will be in global bonds. In contrast to the lockstep march of major global stock markets, global bond markets have been moving with a considerable amount of independence.
“Global bonds have low co-variance due to different yield curves in different countries,” says Randy LeClair, vice president and portfolio manager of $2.5 billion in fixed-income products for AIC Ltd. in Burlington, Ont.

Evidence supports LeClair’s view. In February 2005, while the Merrill Lynch Canadian broad market index (government bonds from one to 10 or more years and all investment-grade corporates) reported a modest 0.06% return, global bond market returns ranged from sparkling gains of 3.51% in Hungary, 3.1% in Poland, 2.4% in Slovakia and 1.94% in South Africa to a rather glum -1.52% in Hong Kong, -1.05% in Mexico and -0.69% in Singapore. For the first two months of 2005, while Canadian bonds in the ML broad market survey returned 1%, returns varied from as much as 7.9% for Polish debt issued in euros to a 1.85% loss for Norwegian bonds issued in sterling.
Bonds classified by national market show much less co-variance than stocks.

The implication is that while investing in several global stock markets may enhance or average return without affecting its direction, investing in global bonds will improve risk-adjusted performance.

Econometric research demonstrates that global bond markets dance to different tunes. In a Bank of England study published in 2000, titled An analysis of the relationship between international bond markets, Andrew Clare and Ilias Lekkos found national market yield curves are not only independent but they are moved by different influences.

For example, the study found that German yields were 70% the result of domestic policy. The other 30% of influences reflected international crises and actions taken by the U.S. Federal Reserve. Britain’s yield curve reflected only 40% domestic factors with the balance of forces showing the power of German monetary influences as well as of crises such as the Exchange Rate Mechanism breakdown in 1992, Asian financial market collapse in 1997 and the Russian debt crisis of 1998.

The Bank of England study shows that domestic economic conditions shape each country’s yield curve, but when there is huge crisis, interest rates rise everywhere in recognition of greater uncertainty in capital markets. What’s more, the stronger the economy of a country, the less an international crisis will affect its bond market. Thus, U.S.-German yields were less affected by shocks, even though the relationship collapsed briefly in the Asian meltdown in 1998.