How To Juice Your Fixed Income Yields With International Money Market ETFs

by on February 15, 2010 | ETFs Mentioned:

For investors in the process of rebalancing their portfolio or taking a step back from the stock and bond markets, money market accounts have historically provided an opportunity to generate returns over the short run while maintaining the flexibility to redeploy assets at any time. During periods of sustained economic growth and bull market rallies, these investments have often provided attractive, risk-free returns. But money market funds have been one of the casualties of the massive stimulus plans implemented in recent years, as a series of interest rate cuts has pared the returns on these funds to record lows. 

Money market rates in the U.S. may be at nearly zero, but the same can’t be said for other markets around the globe (see a list of money market ETFs). Although many of the world’s developing markets have slashed interest rates over the last two years, the rates available on money market accounts in many of these countries remain far above the payouts available in the U.S. Moreover, a handful of developed economies, such as Australia, have already begun raising rates in response to a stabilized economy and concerns about inflation.

With yields on money market accounts and Treasuries too low to compensate many investors for the risks now inherent in the U.S. financial system, many are looking overseas to enhance the fixed income portion of their portfolios. While emerging markets bonds have been a popular choice, others have turned to a seemingly unlikely alternative: currency ETFs.

There are some major misconceptions about currency ETFs among investors. When most think of currency investing, the high-leverage, high-risk, zero-sum game of forex trading generally comes to mind. While currency ETFs obviously are subject to exchange rate risk, the volatility of these investments is generally very low. Moreover, given their underlying holdings, it is perhaps more appropriate to think of currency ETFs as fixed income investments denominated in foreign currencies. So the idea of a “zero sum game” isn’t really accurate either.

Money Market Rates
Brazil 7.1%
South Africa 6.8%
Turkey 6.4%
Mexico 4.7%
Australia 3.8%

Consider the WisdomTree Dreyfus Brazilian Real Fund (BZF). The stated objective of this fund is to achieve “total returns reflective of both money market rates in Brazil available to foreign investors and changes in value of the Brazilian Real relative to the U.S. dollar.” With money market rates near zero in the U.S., many investors are inclined to overlook the first part of this objective, focusing only on the exchange rate impact. But as shown in the adjacent table, the one-month deposit rates available to U.S. investors in certain developed and emerging markets far exceed the single basis point returns available within the U.S. Many foreign money market rates even exceed coupons paid by investment grade corporate debt (the weighted average coupon of LQD is 6.1%).

BZF attempts to achieve these returns by investing the fund’s assets in high-quality U.S. money market securities and entering into similar size forward currency contracts or swaps, which provide exposure economically similar to an investment in Brazilian money market instruments. Because of this current return component, BZF has outperformed the hypothetical return on the real’s exchange rate by a wide margin since its inception.

ETFdb Pro members can see which emerging market currency ETFs was among our actionable ETF investment ideas for February (if you’re not an ETFdb Pro member yet, sign up for a free trial or read more here).

Risk vs. Reward

Investments in foreign money market funds aren’t for everyone. The exchange rate risk of these funds is very real, and a strengthening dollar has the potential to outweigh any benefits derived from the interest earned on the underlying assets. But for investors looking for alternatives to low yield Treasuries and domestic fixed income securities, it may be worth taking a look overseas.

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Disclosure: No positions at time of writing.