At the 49th parallel, you can stand with one foot in two entirely different worlds, fiscally speaking. To the south lies a land wracked with default, foreclosure and runaway deficit spending, to the north a comparative Eden of fiscal probity. The U.S. will spend $1.4 trillion more than it collects in revenues this year, about 11 percent of gross domestic product, and more than any developed country except the U.K. Canada, by contrast, runs an annual deficit of just $54 billion, or 3.2 percent of GDP, and it expects to have all but eliminated the deficit by 2014. Its total government debt has actually fallen in the past dozen years, from 68 percent of GDP to about 34 percent.
Today, 10-year bonds issued by Canada trade at a yield of 3.45 percent. Comparable U.S. Treasurys yield only two-tenths of a point more. If you were going to buy bonds from one or the other, which would you choose?
There aren’t many easy answers in the global financial markets these days, but this question seems to have one. Moody’s Investors Services warned again last week that if the U.S. doesn’t tighten its finances, the nation could lose its triple-A credit rating. While no one expects Uncle Sam to literally walk away from its debts, the Fed could simply print so many dollars that it ends up paying its creditors back in dollars worth far less than those borrowed. “There is more than one way to default,” says Scott Mather, head of global portfolio strategy for Pimco. “The U.S. will most likely [inflate] its debt away.” One could plausibly argue that the Treasury has no other politically feasible choice.
Why take a chance on Treasurys, then, when you could put your bond stake into issues from Canada or other sound countries? The beauty is that such bonds would appreciate in value if the dollar fell, because the return would be in a currency worth more to Americans. Buying international securities is easy enough through mutual funds and ETFs, and for year financial planners have urged clients to move more of their money into foreign stock funds. Why not simply add foreign bonds?
Because, unfortunately, it’s not that simple.
Start with the assumption that inflation is inevitable. While nothing seems more obvious, there are no sure things. The state of U.S. finances is public knowledge, yet 10-year bonds still sell at a relatively low 3.7 percent yield, and the latest Consumer Price Index showed no hint of inflation. “Historically, inflation hasn’t had that much to do with debt,” says Francis Kinniry, a principal in mutual fund giant Vanguard Group’s investment strategy group. “It typically depends more on whether there’s idle capacity in the economy, and in the U.S., there’s still plenty.”
No nation, after all, has a higher debt burden than Japan. Yet its inflation remains close to zero, and the yen is getting stronger, not weaker. While it took more than 120 yen to buy a dollar in 2007, it now takes just 90. And if you can’t count on debt to weaken the dollar, then bonds backed by foreigners aren’t necessarily better for you.
The reason is currency risk. Bonds are meant to be the designated driver in your portfolio, an element of stability among assets (like stocks) whose buyers occasionally seem a little intoxicated. Treasurys held up well when the market tanked in 2008 and helped offset losses in stocks. But foreign bonds are denominated in foreign currencies, so their prices in dollars bounce around with fluctuations in exchange rates. Because of this currency effect, foreign bonds tend to be more than twice as volatile as their U.S. counterparts.
So while it wouldn’t be hard to assemble a portfolio of bonds issued by governments with better credit than our own, that doesn’t necessarily make foreign bond funds the kind of asset you’d want to take home to your mother. “If you add internationals to your bond portfolio,” says Robert Williams, director of income planning at the Schwab Center for Financial Research, “you give up the protective role bonds are supposed to play.”
If you really are convinced that the dollar is doomed to decline, you can add a small measure of internationals to your portfolio — no more than 5 percent or so — but understand what you’re doing. You’re not swapping feckless Treasurys for sobersided German, Swiss and Canadian securities; you are making a currency bet. “Currency movements are unpredictable and volatile, and over the long term they tend to wash out,” says Vanguard’s Kinniry. In other words, you’re speculating on a drop in the value of the dollar. You may be right in the long run, but between now and then, there will certainly be times when you look very wrong.
Financial planners have long said that you should only own bonds that pay interest in the currency you use to buy food and shelter. Despite the dismal state of Washington’s finances, that is probably still good advice. “If I had a dollar for every time people told me, ‘This time is different,’ says Kinniry, “I wouldn’t have to work.” On you next trip to Canada you can bring back all the Labatt’s beer and Toronto Maple Leafs jerseys your American dollars can still buy. What you can’t import, unfortunately, is fiscal prudence.
Reporter: Temma Ehrenfeld
Eric Schurenberg is editor-in-chief of BNET.com, the CBS Business Network.