Sovereign Default Risk & European Bond ETFs €9.4 billion is currently invested in diversified Eurozone government bond ETFs, forming a significant part of the overall European fixed income ETF sector. These ETFs track a diverse range of indices, provided by iBoxx, EuroMTS, Barclays and JP Morgan. The funds have been one of the best-performing segments of the European ETF market over the last 18 months, as investors sought a safe haven from the equity markets, and as interest rate declines gave capital gains to those holding bonds. Until recently, the only real decision a fixed income ETF buyer had to face was where on the yield curve - i.e., the maturity spectrum - to hold bonds. But, since the autumn, there has been another question to consider - sovereign credit risk. Until the end of the third quarter, most Eurozone sovereign issuers had bond yields that differed little from each other at a given maturity, indicating that investors judged them almost equally creditworthy. Since then, as recessionary pressures have intensified, and several European governments have intervened to try and prop up their domestic financial systems, the credit spreads of individual sovereigns have diverged wildly, and are continuing to do so. >From a status quo in which all Eurozone government issuers had credit default >spreads within a range of 0.5% per annum of each other, the differential >between the most and least risky has risen to the current 3%. Ireland now >trades at around 4% per annum for a five-year CDS, whereas even German >sovereign debt requires a default insurance premium of approaching 1%. >From the point of view of the credit derivatives markets, the riskiest euro >member governments were, in declining order and at the end of February: >Ireland, Greece, Austria, Italy, Spain, Belgium, Portugal, Netherlands, >France, Finland, and Germany. There has been increasing speculation that one or more countries could be forced to leave the single currency, although it is quite unclear what the mechanism might be to do so. Plans to issue EU-wide bonds to help support the weaker countries have been mooted, then shelved after criticism by the head of the German sovereign debt agency. Meanwhile, Joaquín Almunia, European Union Economics Commissioner, spoke recently of a plan to rescue any of the 16 single-currency member countries in the case of necessity, although he avoided going into detail. However the current tensions are resolved, it's clear that investors who have bought, or who are considering buying bond ETFs based on Eurozone government bond indices, need to pay close attention to the composition of the indices, and the weightings of the respective government issuers within them Worthy of note in what are capitalisation-weighted indices is the predominance of three countries - Germany, France and Italy - which typically contribute around two-thirds of the overall index. It's also worth mentioning that the riskiest countries in the CDS chart (Ireland, Greece and Austria) have relatively small weightings, particularly so for Ireland. The weightings of the riskier countries jump in the 10-15 year index, with Italy exceeding 30%, Austria 8% and Greece 6% The iBoxx Euro Sovereign index weightings do not differ substantially from those of the EuroMTS indices. Of the riskier countries, Italy's weighting jumps in the 10-15 year and 15+ year indices, as before, and Germany and France remain the other two dominant issuers. The 10-15 year index has a much higher weighting of the riskier sovereigns (Ireland, Greece, Austria, Italy, Spain, Belgium, Portugal) than the other maturity indices. The iBoxx euro liquid sovereigns capped index limits any one country's weighting to 20%, resulting in a boost to the weightings of countries outside the Germany-France-Italy bloc. In particular, from among the riskier countries, Belgium (in the 2.5-5.5 and 10.5+ indices); Spain (in all the indices over 2.5 years); and Greece (in the 2.5-5.5 year index) hit double-figure percentages. The Barclays Euro government indices are the least-diversified of the European government bond indices under review, with some individual country weightings above 40%, and only five countries represented. There is also a big difference in the weightings allocated to individual countries by different maturity band - note Italy's weighting, which varies from 15% to 42% in the indices under review. Germany, France and Italy, taken together, represent around 90% of the index in each case. The JP Morgan GBI EMU index weightings are broadly similar to those of the EuroMTS and iBoxx Euro Sovereign indices, except that the index series does not extend beyond 10 years in maturity. How Are Sovereign CDS Spread Differences Reflected In Bond Yields? It's worth pointing out that the CDS spreads shown in the chart at the beginning of the article do not automatically translate into an equivalent bond yield differential between the countries concerned, for two reasons. First, CDS spreads are typically quoted for a notional five-year maturity, whereas in the case of longer- or shorter-dated bonds, reference should be made to the cost of default insurance at that term. Second, there is the possibility of divergence (basis risk) between CDS spreads and bond yield spreads. Nevertheless, CDS spreads should give a pretty accurate reflection of the real funding costs faced by Eurozone governments. To give an example, Ireland's 10-year bond yield spread over German bonds last week traded at around 250 basis points, a fairly similar spread to that existing between the two countries' CDS. How Might ETF Investors Be Affected? In the worst-case scenario - that of the exit of a country or countries from the euro, or even a default - investors in ETFs tracking indices with high weightings in the countries concerned would face significant losses. The Eurozone bond indices would have to be rebalanced, eliminating the countries affected, but by this time, investors would already have suffered a hit. On the other hand, a resolution of current euro tensions would lead to outperformance by ETFs with large holdings of higher-yielding governments. As things stand, this seems like an outcome with a fairly limited chance of occurring. How To Hedge Those set up to trade in credit derivatives can hedge the sovereign default risk of individual governments by using the CDS market, an option that is not open to many investors. Since the only EU sovereign country bond ETFs available are those tracking UK and German government issues, there's no way of building an ETF portfolio of selected European government bond markets by yourself. If sovereign yield spreads continue to be high and volatile, new ETFs allowing investors to differentiate between individual European government issuers would seem a highly desirable product For a more detailed discussion, see the references below (graphs and tables) http://www.indexuniverse.com/sections/features/5526-sovereign-default-risk-and-european-bond-etfs.html
