The market for sovereign bonds is in turmoil, the result of an epidemic in declining debt quality — brought on by too much debt and stagnant or declining national revenue — that has spread even to global financial stalwarts such as Japan and the U.S. So, if your clients are looking to diversify their global fixed-income holdings, you’ll have to use a new map.

Case in point: U.S. 10-year Treasury bonds, the world’s leading benchmark for fixed-income investing and for holding foreign-exchange credits, aren’t what they used to be. These bonds pay 3.49% to maturity — slightly more than 10-year Government of Canada bonds’ 3.38% to maturity.

However, the outlook for the U.S. dollar is negative, says Sacha Tihanyi, currency strategist with Scotia Capital Inc. in Toronto; thus, U.S. Treasuries could underperform Government of Canada bonds by losing 3%-5% on exchange with the loonie.

Conditions are also declining in other jurisdictions. Not only are some European countries’ bonds in trouble, but the virus of potential insolvency has now also infected Japan, once the world’s most solid debt issuer after the U.S. Treasury. For investors, the worry that Japan may one day default or have to restructure its debt has rattled international bond markets. Indeed, the crisis in global sovereigns is spreading.

Japan’s massive public debt, which is now approaching ¥998 trillion ($8.23 trillion), has led to a downgrade of its bonds by Standard & Poor’s Corp. , which lowered the nation’s sovereign bonds to AA- from AA. The downgrade, which still leaves Japan’s national bonds with a respectable rating, say bond traders, is a herald of worse to come.

Japan’s core problem is that its aging population — now the oldest of any G7 country — is drawing government social services benefits and, at the same time, cashing in government bonds and taking money out of the nation’s postal savings banks, which had put savings into government bonds. Eventually, Japan may no longer be able to finance its massive debt — which now stands at 200% of gross domestic product — internally, as it had done for decades.

If that were to happen, bonds such as the 10-year Government of Japan issues that pay 1.23% to maturity, will drop drastically in price as the Bank of Japan raises rates to attract foreign capital. The looming crisis is yet another sign of the woes of global sovereign debt issues that were presaged by the problems of Greece, whose national bonds trade at 776 basis points over comparable 10-year German bunds, and of Ireland, whose sovereign bonds trade at 546 bps over the bunds.

“One day, Japan will approach a crisis point in financing its public debt,” says Richard Gluck, principal in charge of global bonds with Trilogy Advisors LLC in New York. “At the moment, the domestic level of savings is still high enough that the crisis is not [there]. I cannot predict when it will come, but it will.”






@page_break@At that point, Japan’s bonds, once the mainstays of global debt markets, could join Greece’s and Ireland’s sovereign bonds in the doghouse of global finance.

Japan’s case of debt bloat has raised risk premiums in global bond markets. You could buy Japanese bonds, not for their low yields but as a play on the yen. But Japan’s massive debt now hangs over the currency as well, Tihanyi says: “We are bearish on the yen.”

A drop in the yen’s exchange value and a rise in Japanese interest rates would devastate foreign holders of Japanese bonds.

Nevertheless, diversification into global bonds remains a good fixed-income strategy, says Graeme Egan, portfolio manager and financial advisor with KCM Wealth Management Inc. in Vancouver. He notes that with Canada bond rates still low, no inflation problem and no evident policy move by the Bank of Canada to raise rates, income-seeking investors have to look abroad. Says Egan: “Look for countries with appreciating currencies.”

Although those are hard to find these days, Brazil and Thailand are worth a look. Brazil is the best of the developing countries’ debt issuers. It runs a primary budget surplus, taking in more money than it spends. Its bonds look attractive. Brazilian government US$-denominated 10-year issues pay 4.55% to maturity, which is 106 bps over 10-year U.S. Treasuries.

Thai 10-year bonds, on the other hand, pay 3.72% to maturity — with an expectation of a push to raise interest rates by the Bank of Thailand, whose policy is directed at curbing inflation.

The downside of investing in these bonds is heavy taxation on capital inflows. Brazil charges a 6% tax to foreign investors who want to put money into its capital markets, and that could rise to 8%, Gluck says. Meanwhile, Thailand will impose a withholding tax on bond interest paid to foreigners, notes Bloomberg LP. Foreign tax credits allow Canadian investors to use these taxes paid to reduce Canadian taxes payable on interest, but the taxes reduce yield.

The best bet for now in foreign bonds is Australia, says Christine Horoyski, senior vice president for fixed-income with Aurion Capital Management Inc. in Toronto: “[Australia] is my favourite foreign market. It is sophisticated and liquid, with a 5.59% yield on a bellwether federal bond. The currency is on par with the Canadian dollar.”

New Zealand’s 10-year federal bonds, which pay 5.547% to maturity, are also a good option, she says. In addition, Horoyski points out, both Australia and New Zealand have currencies that are unlikely to fall against the C$ and governments that are understandable in Canadian terms. IE