With Global Yields Stuck, Look To Profit From Currency Appreciation

sovereign bondsGoing From An Idea To Making An Investment

The idea phase: We all have moments of inspiration where something strikes us as odd or unusual. Recently, I was looking at the yield on 10 year government bonds from around the world and noticed how similar the yields were on several of the world’ most developed economies. Of the G-7 nations (the world’s 7 most developed economies), 5 of them have yields that are within a half a percent of 2%. The exceptions are Japan (JGB) of 0.83% on its 10 year bond and Italy with a yield of 4.26%.

  To see a list of high yielding CDs go here.  

Yields of 5  Developed Nation’s 10 Year Government Bonds

Country and Bonds Name Yield
U.S. Treasuries 1.90%
U.K. Gilts 2.12%
German Bunds 1.54%
French OATs 2.14%
Canadian Government Bonds 1.94%

Which is the best investment choice?

There are going to be three components to the total return when investing in these bonds: interest payments, price movement in value of the bonds, and currency movement. Let’s dive into each of these:

Interest Payments:  With the possible exception of German Bunds with yields about ½ a percent less than the rest, the yields are so close that I consider them all about equal.

Price movements:  When interest rates move higher, bonds lose value. However, we usually are referring to US Treasury rates when we say “interest rates”. Interest rates for one country can move up or down without it impacting another. However, all the countries being considered are dealing with a global economic slowdown and are keeping short-term rates very low to stimulate their economies.  With short-term rates so close to zero, there is little room for countries to lower their rate. There is only one country which has been talking about the need to raise rates in the next couple years: Canada.

Currency Movements: As I live in the United States, I measure my returns in US dollars. If I buy a bond denominated in a foreign currency (that pay its principal and interest in that currency), my returns will be directly impacted by currency movements. If I buy Canadian bonds and the US dollar loses value against the Canadian dollar , I will make money directly in proportion to the currency move.

Is there a country whose currency I believe might increase in value against the United States? Yes, I am bullish the Canadian Dollar.

 

Why am I bullish on the Canadian Dollar?

  1. The Canadian economy as measured by the unemployment rate at 7.1% is recovering much faster than the United States.
  2. Government spending is under control. Canada is running a modest annual deficit of 1.5% of GDP versus 6-7% for United States. On top of having more spending discipline, Canada has a lower relative debt than the United States, when compared to the size of its economy. The debt to GDP ratio for Canada is  85% versus 103%.
  3. Canada’s central bank is likely to be the first to start raising interest rates, making it more attractive to hold Canadian debt.

In short, Canada has a responsible government, a recovering economy (although sluggish GDP growth), and a central bank which is more conservative than the rest of the developed world.  I would much rather hold Canadian government debt than US Treasuries because of the chance for currency appreciation. However, the fact that interest rates might rise in Canada is a double edge sword. While good for the currency, its bad for the future value of its bonds. To minimize the potential loss in value to due to higher interest rates, I would want to own shorter-term Canadian Bonds.  So, I have my investment idea.

 

Where does this investment idea fit within a bond portfolio?

An investment portfolio is more than just a bunch of good ideas.  You can have a bunch of great investment ideas and a terrible portfolio. Why? Because certain types of assets tend to move together. As there are always unforeseen events,  its a good idea to put one’s money in multiple assets and try limit one’s exposure to a variety of risks. In the case of adding Canadian bonds to one’s portfolio, one would not want to be loading up one’s portfolio with too many bonds or too many assets with exposure to foreign currency.

 

Does one’s portfolio have too many bonds?

Learn Bond’s believes that a portfolio should be about 40% in bonds. Will adding short-term Canadian bond’s push one’s portfolio over 40% mark? If so, one might want to reduce another type of bond holdings. As Canadian bonds are very safe (in terms of default risk), one might look to reduce holdings of similarly safe bonds like US government bonds or agency mortgage backed securities. One way this can be done is by reducing one’s holding of core bond funds.

 

Does one’s portfolio  have too much exposure to foreign currency

Learn Bond’s believes no more than 50% of one’s portfolio should be invested in non-foreign dollar assets. However, the 50% should not be in one investment or one area of the world. For a very targeted investment in one currency, I would say a good rule of thumb is about 15% maximum investment, no matter how good one’s investment idea. One should always consider how the investment will affect, one’s overall portfolio.

So far, we have an investment idea – buy short-term Canadian bonds and limit one’s exposure to under 15% of one’s portfolio. But how exactly should one make the investment?

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