The Canadian dollar may be dropping against the greenback this morning, but remains relatively strong when compared to other global currencies, notably the euro and the British pound. For any investors still in the European bond market, the soaring loonie threatens to gobble up any gains made there.
“Currency movements can very easily wipe out the benefits of a bond portfolio’s gains,” says Heather McOuatt, lead manager of the Bissett Bond Fund. Not only are the capital values of European bonds swinging wildly, but exchange rate fluctuations can magnify volatility.
In a bond portfolio, investors reap returns through different sources. The most obvious is the coupon paid by the bonds. McOuatt says normally that would be the total return for the year. “When you add currency risk to the bond portfolio, the percentage of your portfolio in the foreign denominated bond would certainly be impacted by moves in that currency,” adds McOuatt.
The euro has been taking a severe hammering as the Greek debt drama continues to unfold. Investors are increasingly wary of the region’s financial system.
“The problem with the euro is that people are not confident about the European economy,” says Sadiq S. Adatia, chief investment officer, Russell Investments Canada. He is hedging all his bets on Europe. “It is probably not a bad idea to be hedging off the euro exposure because the euro is probably going to remain low for some time.”
In the short run, though, he says it might be alright to take a flyer, as most of the currency losses have probably been made. There is no catalyst that can cause the euro to bounce back any time soon, and that means investors are not going to lose their shirts in the short term if they choose to remain unhedged, says Adatia. But in the same breath he warns the world may not have seen the worst of the crisis yet.
“You might want to consider hedging off the euro exposure in case it drops a bit further as a result of more negative news.”
The recent volatility has had investors rushing to the safe haven of U.S. Treasuries, a destination that McOuatt says will continue to be the best bet for flight to safety.
“The U.S. Treasury market is the ultimate vehicle for flight to quality bids,” she says. “It’s the largest bond market in the world. And, of course, the U.S. dollar, despite all the issues plaguing the U.S., is going to remain the reserve currency and enjoy that status that goes with it.”
Given the debt problems facing the U.S., a Canadian investor may wonder if Treasuries are really such a safe play. Will foreign investors ever see Canadian bonds in a similar light? The response from both McOuatt and Adatia is a resounding “no.”
McOuatt, however, offers some consolation. “The benefit of not being (the destination) is that we have a little less volatility in Canada, which is a good thing for a bond manager.”
Inflation equation
Those battling with inflation-inspired insomnia can take comfort in McOuatt’s insight.
“It is still too early to start worrying about inflation,” she says. Inflation fears are elevated due to the amount of monetary and fiscal stimulus. Until deleveraging has run its course there remains a huge output gap between Canada and the U.S.
“In addition, we have the velocity of money, which has completely offset the increase in fiscal and monetary stimulus through the various central bank and government programs,” she says, adding that the fear of inflation is unwarranted until the velocity of money begins to accelerate.
Corporate versus sovereign debt
“We are longer-term bearish on sovereign debt given our view that interest rates will be rising, particularly in the short end of the curve,” says McOuatt. “However, given our expectation for more muted inflation, we don’t think that the mid- to the long-end portion of the curve will be as negatively impacted.”
Generally speaking, the price of corporate debt at this time is pricing in more of a recessionary environment, she says, and current low prices suggest “corporate debt will outperform government debt over a longer time horizon.”
(05/25/10)