In recent years, you may have caught news of rising interest rates or the highest bond yields in more than a decade. These reports should suggest attractive opportunities for short-term savings appreciation at low risk. We are talking about funds that will be needed in one to three years' time. Households do not want to take risks with these resources because they usually have a specific target for use.

At the same time, however, it is a pity to leave them lying around in savings accounts, as most Slovak banks have still not increased their interest rates to reflect market interest rates (e.g. the ECB deposit rate is currently 4%, you can compare this with the interest on your savings account yourself).

An alternative is fixed-term deposits, which often require other conditions to be met in order to get a favourable interest rate, such as making a minimum deposit, buying a mutual fund from the bank, or opening another fixed-term account with a longer commitment period. In addition, you have to pay a 19% tax on income from fixed deposits.

The smart wallet has been created for people who are looking for a golden middle ground. It gives its investors access to short-term interest and safe bond yields, has no tie-up and its returns are tax-free for Slovak tax residents after one year of holding.

Basic Parameters of the Intelligent Wallet

It is the Intelligent Wallet that addresses the problem of short-term savings. After months of analysing the returns and risk of different asset classes, a product with the following parameters has seen the light of day:

• current gross yield 3.7% p.a. (as of 31.10.2023)*,
• minimum possible risk (wide diversification among a number of corporate and government bonds, short maturity ensuring low sensitivity to interest rate changes),
• portfolio management fee of 0.5% p.a. including VAT,
• no entry fees, neither for payment processing nor for investment advice
• Slovak tax resident returns are tax-free after one year of holding.

In short, the product aims to provide investors with access to money market and bond market returns with minimum risk and fees.

*Note: The yield shown is calculated as a weighted average of the yields to maturity of the underlying ETFs as reported by the fund managers in their monthly reports to 31.10.2023. The gross yield takes into account the funds' fees, but not the Finax fee of 0.5% p.a. including VAT. The yield is variable and will change in the future based on changes in interest rates by central banks and investor sentiment in the market. The tax treatment depends on each client's individual circumstances and may change in the future.

How the product was formed and what the journey showed us

Several of you may have heard that both the bond and money markets are offering record returns for the first time in a long time. The ECB deposit rate has risen steadily to 4%, the highest level since the creation of the euro. The bond market is not lagging behind. For example, the yield on safe German government bonds recently surpassed a 12-year high, rising to almost 3%.

Achieving an annual appreciation of 3-4% on short-term savings is a respectable result. The wallet therefore aims to make these returns available to ordinary investors. We selected the portfolio from among exchange-traded instruments so that clients could also take advantage of the tax exemption. Fortunately, today's era also offers instruments replicating the ECB short-term rate, at which ordinary people cannot directly invest.

Another issue was the appropriate risk adjustment. Probably nobody wants to see significant fluctuations in the value of their short-term savings or a high probability of major drawdowns. To understand how risk works in the Wallet, let's start by briefly explaining how bonds work. It is these instruments that play a dominant role in the Wallet, as in any conservative portfolio.

Each bond has a specific maturity, which can range from a few months to decades. During this period, the bonds pay their holders regular fixed interest payments. At maturity, the bond pays off the principal and is retired.

Because bonds have fixed payments and you know their price when you buy them, you can already estimate how much you could earn when you buy them. In short, you compare the promised fixed payments to the bond's price (the initial deposit) to see how much more you'll get back (i.e. how much you'll appreciate your deposit by). The resulting percentage is quoted on an annual basis and is called the yield to maturity by investors.

However, once you have invested your deposit, you will face two main types of risk. The first is called credit risk. This is the threat that the bond issuer will not pay you the full promised return (e.g. because of a bankruptcy filing). 

You can best eliminate this risk by diversifying widely among a number of bonds from governments and companies around the world. It also helps if these issuers have high credit ratings from independent rating agencies (i.e., they are investment grade). If you invest in such a diversified portfolio, bankruptcies will usually only affect the minimum amount of payments. Therefore, if you hold it to maturity, the resulting return on your investment is highly likely to be similar to the return to maturity at the time you bought the bonds.

However, the second type of risk should not be forgotten: interest rate risk. Before maturity, the price of the bonds will fluctuate. Interest rates are one of the main factors that determine bond price changes. Bond prices move in the opposite direction to interest rates. If the central bank raises rates, the value of the portfolio will go down. If interest rates fall, the value of the portfolio will rise. That's why we say you take interest rate risk when you invest in bonds.

The key question is how much your portfolio will fall or rise in response to a change in interest rates. We can measure the sensitivity of bonds to changes in interest rates using what is known as duration. It's not complicated, it's basically the number of years it takes a bond to pay its holder back the amount invested (i.e. how long it takes to get your money back).

The longer the duration, the more sensitive the value of the bond is to changes in interest rates. You can therefore reduce portfolio fluctuations by investing in a portfolio with a shorter average duration. The main influence on the size of the duration is the maturity and interest rate of the bond or bond portfolio.

This difference is best shown in the chart. The blue line shows the evolution of the value of an index focusing on euro area government bonds with a maturity of 1-3 years. The orange line represents an index of euro area government bonds with a maturity of 5-7 years. As the latter index contains bonds with longer maturities, it will also have a higher average duration. You can see that this index flies much more aggressively to the downside as well as the upside and will see a deeper decline if interest rates rise.

Don't be spooked by the long period during which bonds on the chart did not rise. The central bank kept interest rates below zero for most of that period. Since then, however, rates have risen sharply, and today both bonds and the money market are finally offering attractive yields after a long time. Conservative investors have thus seen the return of the bond era.

Source: Bloomberg. For bonds with a maturity of 1-3 years, this is the FTSE Eurozone Government Broad IG 1-3Y Index. For bonds with a maturity of 5-7 years, this is the FTSE Eurozone Government Broad IG 5-7Y Index. Past returns are no guarantee of future returns.

In developing the Wallet, we have therefore aimed to keep the duration below 2.5 years by including bonds with shorter maturities. This way, the value of the portfolio will not be too sensitive to changes in interest rates and the bonds will pay a return over a shorter period corresponding to an investment horizon of 1-3 years.

Composition of the Intelligent Wallet

The Wallet consists of a bond component and a cash component. The former has been given a 60% share in the portfolio, the latter a 40% share. The Intelligent Wallet is thus a combination of the bond and money markets. In more detail, it consists of the following funds:

Source: Monthly ETF fund reports as of October 31, 2023.

40% of the portfolio consists of a fund focused on government bonds of the largest euro area economies with maturities of 1-3 years. The bonds must be issued in euros and have a high credit rating (belong to the so-called investment grade, i.e. bonds with a very low chance of default). For example, bonds of the governments of France, Italy, Germany, Spain, Austria or the Netherlands are represented.

A fund containing bonds of companies from all over the world issued in euro with a maturity of 1-5 years is represented by 20%. They must also be investment grade, so they are the debt of the highest quality companies in the world.

A 39.4% stake has been taken by a fund that aims to replicate the short-term €STR (the price at which banks borrow excess reserves overnight). The public cannot invest directly at this interest rate, so the ETF replicates it using so-called swaps. Its current annual return is 3.97% (as of 31.10.2023) with zero reactivity to interest rate changes (its duration is therefore zero).

This composition represents the current tactical allocation, which the investment strategy allows us to adapt to a new situation in the event of a rapid change in market conditions (in particular sharp changes in interest rates). In such a case, we will be able to add a small equity component to the wallet (up to a 20% holding), change the money and bond market ratio or adjust bond maturities (however, the total duration of the bond and money components of the portfolio can never exceed 2.5 years).

It is certainly not our intention to make such changes frequently; rather, they are intended to protect investors in the event that a change in market conditions makes the current set-up objectively unfavourable (e.g. if interest rates were to fall back to zero or into negative territory). We will inform you in advance of any changes to the Wallet portfolio.

You can read the full text of the Intelligent Wallet investment strategy at this link.

Note: Investing always involves risk associated with the development of the financial markets.

What is the difference between Smart Deposit and the Intelligent Wallet?

Finax currently offers two conservative products suitable for short-term savings. In addition to the Intelligent Wallet, clients can also choose the Smart Deposit. You may be wondering which of these portfolios is better suited to your needs.

Both portfolios are built on similar asset types, specifically bond and cash ETFs. The smart money portfolio contains a lower money market weighting and its bonds have slightly longer maturities.

This difference implies that the Wallet provides a higher expected return over the long term in exchange for a higher risk of fluctuations in value. Indeed, bonds with longer maturities have a higher yield in most periods than comparable bonds with shorter periods to maturity, as they carry a greater risk of fluctuations in value in response to changes in interest rates (for which they must reward investors with a yield premium).

The Smart Deposit is more resilient to potential interest rate increases. The extremely short maturity of its components ensures almost zero sensitivity to interest rate changes. Because of its longer maturity, the smart wallet may fall slightly in the event of a sharp rise in interest rates.

Conversely, the Smart Deposit is more vulnerable to interest rate cuts. This is because its return is more directly linked to the ECB deposit rate. Thus, if central bankers cut interest rates during the savings period, the Smart Deposit stops paying the increased return.

The Intelligent Wallet will benefit from the reduction in the short term, as its resulting rise in bond prices will kick-start the yield. Note, however, that even the instruments in the Wallet would start paying a lower yield in the following period once this effect wears off.

Since the portfolios are very similar, we recommend you make your decision simply based on your investment horizon. If you need the funds within one year, use the Smart Deposit, in which your savings will be subject to almost no fluctuations. If you will need the funds in 1-3 years, choose the Intelligent Wallet. In that case, you can already afford slight fluctuations in value in exchange for the yield of bonds with longer maturities.

The Intelligent Wallet offers a solution for short-term savings with a horizon of 1-3 years. It aims to make higher bond yields and money market interest available to investors at minimum risk and fees.

Finax no longer only offers solutions for medium and long-term savings and wealth building, but also for short-term reserves and expenses. The Smart Wallet is another product of our financial services expansion aimed at offering Central Europeans comprehensive personal finance care services all under one umbrella.