Risk/Return Trade-Off: Currency versus Interest Rate Risk
While we only briefly discussed the fixed income asset allocation decision above, it is worth having a discussion about currency risk in European fixed income. Unlike a U.S. dollar-denominated fixed income investment, broad-based European fixed income funds such as the WisdomTree Euro Debt Fund (EU) provide exposure not only to European interest rates but to the value of the euro as well. While we believe that a long-term consequence of rising rates in the U.S. will be a strengthening of the U.S. dollar against the euro, currency exchange rates are determined by many more factors than just interest rate differentials. As a result, the primary reason we believe European bonds could offer value relative to U.S. fixed income is because we believe that losses from rising U.S. interest rates could exceed losses caused by a depreciation in the value of the euro in the near-term.
In sum, ETF flows can be a valuable indicator for investors to quantify which segments of the market are attracting assets. In the current environment, many U.S. investors see value in European markets. Going forward, European fixed income may provide greater potential for total returns as central bank policies between Europe and the U.S. diverge.
1Source: Bloomberg, as of 5/31/14.
2Source: Bloomberg, as of 5/31/14.
3Source: WisdomTree, as of 5/31/14.
4Source: ECB, 6/5/14.
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. Funds focusing their investments on certain sectors and/or smaller companies increase their vulnerability to any single economic or regulatory development. This may result in greater share price volatility. Investments in currency involve additional special risks, such as credit risk and interest rate fluctuations.
Derivative investments can be volatile, and these investments may be less liquid than other securities, and more sensitive to the effect of varied economic conditions. As HEDJ can have a high concentration in some issuers, the Fund can be adversely impacted by changes affecting those issuers. Due to the investment strategy of HEDJ, it may make higher capital gain distributions than other ETFs. 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.