For U.S.-based investors, should the euro depreciate against the dollar, unhedged positions in short-duration European debt would likely experience losses on a total return basis, as the income potential and capital gains would not be sufficient to offset losses from the currency.
In our view, investors should increase allocations to intermediate-term euro-denominated debt as a contrarian play on the euro. In this scenario, investors have the potential to be compensated with higher amounts of income for assuming greater interest rate risk. Given that investors have a greater sensitivity to changes in rates, these positions would also stand to appreciate by a greater amount than deposits, should intermediate-term bond yields fall.
Conclusion
While we believe that European policy makers will ultimately engineer a rebound in inflation and a depreciation of the euro against the U.S. dollar in the long run, investors should consider increasing allocations to euro-denominated debt as a way to opportunistically trade on Draghi’s reluctance. As the only pure-play euro bond exchange-traded fund (ETF), the WisdomTree Euro Debt Fund (EU) may be attractively positioned to continue to benefit from the ongoing deflationary tendencies in the eurozone.
1Source: Bloomberg, 7/26/12.
Important Risks Related to this Article
There are risks associated with investing, including possible loss of principal. Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty. Investments focused in Europe may be impacted by events and developments associated with the region, which can adversely affect performance. Derivative investments can be volatile, and these investments may be less liquid than other securities and more sensitive to the effects of varied economic conditions.
Fixed income investments are subject to interest rate risk; their value will normally decline as interest rates rise. In addition, when interest rates fall, income may decline. Fixed income investments are also subject to credit risk, the risk that the issuer of a bond will fail to pay interest and principal in a timely manner, or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.
Investments in currency involve additional special risks, such as credit risk and interest rate fluctuations. Unlike typical exchange-traded funds, there is no index that the Fund attempts to track or replicate. Thus, the ability of the Fund to achieve its objective will depend on the effectiveness of the portfolio manager. Due to the investment strategy of this Fund, it may make higher capital gain distributions than other ETFs. Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile.