WHY INVEST OUTSIDE CANADA?

In today’s increasingly complex financial environment, it is sometimes hard to maintain one’s bearings. All investors seek to maximize their return and minimize risk. To that end, investing outside Canada, whatever the asset class, is a strategy worth considering.

This article provides an overview of Canada’s two major asset classes and their current situation. Issues associated with foreign investment and two often-neglected asset classes—foreign bonds and global dividend-paying stocks—will also be examined.

OVERVIEW OF CANADA’S TWO MAJOR ASSET CLASSES

EQUITIES

Canada’s stock market returns over the next few years may be challenging. The International Monetary Fund (IMF) is predicting slower global growth, on which our natural resource-based economy is largely dependent. In addition, Canada’s economy is facing a number of challenges. Government, at all levels, and the population are becoming increasingly indebted. Government spending, particularly at the provincial level, is on the rise, making it harder to balance budgets. Furthermore, consumers will face higher interest rates and, in all likelihood, a slower growth rate in real estate prices, according to a number of economists.

Canada’s economy is facing a number of challenges

Due to these factors, it is unlikely that households and governments, whose combined spending accounts for nearly 80% of Canada’s GDP growth1, will be able to increase their spending and significantly boost GDP. This scenario of weak domestic and global growth is not good news for Canadian stock markets.

BONDS

Canada’s low interest rate environment in recent years, helped by massive monetary injections by most major global central banks, is likely to continue for a few more years. Interest rates should, however, begin edging closer toward historical averages. The current yield (or yield to maturity) of bonds remains very low in Canada. For example, the DEX Universe Bond Index’s current yield was 2.71% as at September 30, 2013.

Low current yields, combined with a potential interest rate hike, could complicate the performance of Canadian bonds over the next few years. This has been the case since last May: the DEX Universe Index’s total return since April 30 is -3.35% (as at September 30, 2013).

1 Source: Statistics Canada (data as at June 28, 2013).

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Structure of global economy and growth dynamics are changing rapidly

SOURCE: International Monetary Fund (IMF), World Economic Outlook April 2013

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AVERAGE REAL GDP GROWTH FORECASTED FOR 2014 (PERCENT)

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THE SOLUTION: INVEST OUTSIDE CANADA

When you invest around the world, you gain access to opportunities in all markets. Why limit yourself to Canada-based companies (or bond issuers) when the Canadian market accounts for only 4% of total world stock market capitalization? Why limit the potential pool of securities to choose from?

AVERAGE REAL GDP GROWTH FORECASTED FOR 2014 (PERCENT)

In addition to gaining access to a much larger investment universe and to markets offering better economic growth prospects than in Canada (as shown in the diagram), you will benefit from the fact that the markets don’t always react to an event the same way. When you invest in foreign assets, your potential return is higher—and you mitigate portfolio risk at the same time!

Source: International Monetary Fund (IMF), World Economic Outlook April 2013

INVESTING IN FOREIGN EQUITIES

Canada’s economy is largely dependent on its natural resources; this explains why the Canadian stock market is concentrated in the resource sectors. We are also largely dependent on the strength of the U.S. economy (the U.S. is our largest trading partner by far and receives 70% of Canada’s exports of goods and services).

As shown in the accompanying diagram, the Financial Services, Energy and Materials sectors account for over 70% of the S&P/TSX Index. In addition, 87% of the index is made up of cyclical sectors, i.e., those that move up and down in step with the broader economy. In contrast, companies operating in the defensive sectors (Consumer Staples, Health Care, Telecommunications and Utilities), which make up the remaining 13%, generate more stable revenues, regardless of the strength of the broader economy. In comparison, the defensive sectors account for 28% of the MSCI World Index. So one advantage of investing in foreign assets is that your portfolio is better balanced across sectors.

As for dividend-paying stocks, it comes as no surprise that only two sectors (Financial Services and Energy) account for 60% of the S&P/TSX Equity Income Index, which serves as the benchmark for these equities in Canada. Generally speaking, dividend-paying stocks offer a protective “cushion” during bear markets (i.e., when stock prices are trending downwards) since the dividend payments provide an additional level of security. In addition, this equity type is usually less volatile, in part because a significant portion of the total return (i.e., the dividends) has a lower volatility (as measured by the standard deviation) than that of the overall equity market.

Dividend-paying stocks are usually less volatile

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In addition, dividends are very important for people looking for additional revenue streams, such as retirees. As the world’s population is growing older, dividend-paying stocks are likely to remain popular for many years to come. The attraction of foreign equities and dividend-paying stocks demonstrates the importance of having foreign dividend-paying stocks in your portfolio.

INVESTING IN FOREIGN BONDS

Canada’s bond market is relatively expensive and highly concentrated. As shown in the table below, bonds issued by Canadian companies pay a lower risk premium (compared with local government Treasuries) than that of U.S. corporate bonds or sterling-denominated bonds in various sectors and credit rating categories. These foreign opportunities enable you to increase your current yield and your portfolio’s potential return.

SNAPSHOT OF CORPORATE BOND CREDIT SPREADS AS AT JULY 2013

Overall Index Financial Industrials Utility AAA AA A BBB

U.S. Corporate 141 148 137 131 59 76 106 194

Euro Corporate 104 126 78 110 46 39 71 166

Sterling Corporate 181 232 138 157 64 95 139 251

Canada Corporate 85 68 107 98 35 48 78 128

Based on Bank of America Merrill Lynch US Corporate, Euro Corporate, Sterling Corporate, Canada Corporate indices and sub-indices. All credit spreads are in basis points and are calculated over the respective interest rate swap curve. Source: Bank of America Merrill Lynch, PIMCO.

Another equally important factor to keep in mind is that the Canadian bond market is highly concentrated. The DEX All Corporate Bond Index’s 10 largest corporate issuers account for 44% of the index, much higher than for similar indices in the U.S. (approximately 15%), Europe (18%) or the U.K. (23%).2 The universe of issuers, the number of bond issues and the notional value of bonds outstanding are much smaller in Canada. For example, the notional value of bonds outstanding on the Barclays Global Aggregate Corporate Index (a Global Corporate Bond Index) is 20 times larger than that of the DEX Canadian Corporate Bond Index; it also has 10 times more bond issues and eight times more bond issuers.

LIQUIDITY COMPARISON OF COMMON CORPORATE INDICES

DEX Canadian Corp.

DEX Canadian Corporate Long

Barclays Global Agg. Corp.

BofA ML US Corp.

Barclays Euro Agg. Corp.

BofA ML Sterling Corp.

Number of issuers 148 75 1,300 1,036 327 237

Number of issues 793 264 8,037 5,782 1,339 694

Notional outstanding ($M) 337,000 69,000 7,363,000 4,209,000 1,562,000 286,000

Source: Bank of America Merrill Lynch, Barclays, PC Bond Analytics (DEX indices), PIMCO, as at July 2013.

2 Source: Bank of America Merrill Lynch, Barclays, PC Bond Analytics (DEX indices), PIMCO, as at July 2013.

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By investing in foreign bonds, you gain access to more bond issuers, healthier corporate/government balance sheets and markets offering higher real interest rates. You also benefit from countries in which central banks still have a little wiggle room when it comes to reducing their overnight rate (and you can thus potentially benefit from an increase in the bonds’ market value). For example, the Reserve Bank of Australia has lowered its key rate by 225 basis points since November 2011.

In order to diversify the fixed-income portion of your bond portfolio while increasing your current yield and potential total return, you would be well advised to add foreign bonds.

POTENTIAL FOR BETTER RISK-ADJUSTED RETURNS OUTSIDE THE U.S. AND CANADA

Source: Bloomberg. Data shown are represented by 5-year swaps as at June 30, 2013.

Many investors have been investing in stocks outside Canada as a matter of course for a number of years. Until recently, however, foreign bonds and dividend-paying stocks were not typically included in investors’ portfolios.

Nevertheless, these asset classes are so attractive that we must ask the following question: if a portfolio would benefit from including foreign bonds and dividend-paying stocks, why not do so?

If a portfolio would benefit from including foreign bonds and dividend-paying stocks, why not do so?

pg 25Your Global Investment Authority

Global yields can diversify U.S. duration exposure

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As of 30 June 2013SOURCE: BloombergData shown are represented by the 5-year swapsRefer to Appendix for additional risk information

Potential for better risk-adjusted returns outside the U.S. and Canada

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