European investors this year found safety in short-term US debt and the dollar.
Interest rate policy forecasts are an international sport among economists and investors. The Fed raised its policy rate by 75 basis points four times but is preparing to shift to a 50-basis-point hike in the near future. While that was seen here and there as the beginning of the end of interest rate hikes, bank president Jerome Powell reiterated that there is still work to be done on fighting inflation.
‘All about the Fed’
Central bank policy has received much criticism over the years, including from top economist Mohamed El-Erian. Who recently said that the Fed made two major mistakes. First, by wrongly describing inflation as temporary and transitory and then by failing to act immediately once they had acknowledged their first mistake. Moreover, El-Erian fears that the now tough but belated action could plunge us into recession.
Besides raising policy rates, central banks largely withdrew from the capital market, forcing institutional investors such as pension funds and insurers to take over again. Not surprisingly, their return expectations are considerably higher than those of the central bank before.
Deep corrections
The tightening monetary policy triggered a correction in bond markets that was unforeseen for many investors. The Bloomberg Aggregate Bond Index, one of the most widely used indices for broad and global bond exposure, lost 8 per cent of its value measured in euros so far this year (as of end-November). However, regional differences are wide. The Bloomberg Euro Aggregate Bond index lost 14.1 per cent while the US equivalent fell just 3.5 per cent.
The deep fall this year could potentially be an interesting entry level for those investors who ignored bonds for years, especially in a recession scenario, according to many strategists. The yield on US Treasuries stood at 3.6% for the 10-year, 3.79% for the 5-year and 4.39% for the 2-year on Monday 5 December, respectively, while investors were getting just 0.75%; 0.35% and 0.15% on the same bonds some two years ago.
Importance of exchange rates
For European investors, short-term US debt issued in US dollars was just about the only safe haven this year. The combination of higher yields (than those on euro bonds) and dollar strength made this an attractive asset class, but there is disagreement among economists on whether this trend can continue next year.
ABN Amro anticipates further rate hikes in the first half of 2023, but expects that in the second half of next year, Fed rate cuts will be stronger than market expectations. This should result in a stronger EUR/USD exchange rate. In contrast, Rabobank’s Jane Foley sees enough potential for USD bulls to become active again. A requirement for further dollar weakness is for investors to move into riskier currencies and the strategist sees that as unlikely as long as the Fed continues to raise interest rates, even if in small steps.
Top-5
For this week’s Top-5, we look at mutual funds in the Morningstar Category USD government bonds whose distribution fee-free fund class is available in the Netherlands. These five funds have shown the best performance based on returns over the first 11 months of 2022.
It should come as no surprise that the list consists entirely of funds dedicated to floating rate or short-term bonds given their lower interest rate sensitivity. What also becomes immediately clear is what the impact of currency effects has been.
WisdomTree USD Floating Rate Treasury Bond
In first place, we find a floating rate treasury bond fund from WisdomTree. This ETF managed to present a nice return of 12.2 per cent in euros so far this year. The WisdomTree USD Floating Rate Treasury Bond Ucits ETF tracks the Bloomberg Barclays U.S. Treasury Floating Rate Bond index, which measures the performance of floating-rate bonds issued by the US Treasury. These are not eligible for inclusion in the Bloomberg US or Global Aggregate indices as they are not fixed-rate securities. Unlike US government bonds with fixed coupon rates, the coupon rates of these securities are expected to be adjusted weekly based on the results of the most recent US government bond auction. The yield will better reflect changes in short-term US interest rates given that the coupon amount is linked to interest rate movements.
Eurizon Bond USD short-term fund
Amid ETFs, we see the Eurizon Bond USD short-term fund managed since May 2019 by Andrea Giannotta, head of fixed income securities at the Italian manager. The fund normally invests at least 80% of total assets in debt securities issued by the US government and the credit rating and maturity generally match those of the JP Morgan Government Bond United States 1-3 Year benchmark. Up to 20% can be invested in corporate and non-US debt securities.
iShares USD Treasury Bond 1-3yr Ucits ETF
iShares USD Treasury Bond 1-3yr Ucits ETF as well as those offered by Lyxor and UBS give investors exposure to short-term US government bonds. The underlying Bloomberg US Treasury 1-3 Year index can present a year-to-date return of 6 per cent measured in euro while the Bloomberg US Treasury 10+ Year index lost 19.4 per cent over the same period.
Top 5, based on Netherlands classification:
Top 5, based on Belgian classification:
Thomas De Fauw is a manager research analyst at Morningstar. Morningstar analyses and evaluates investment funds on the basis of quantitative and qualitative research. Morningstar is one of Investment Officer’s knowledge partners and ranks five investment funds or providers each week.