|Deconstructing Eurozone Bond ETFs|
|21 July, 2011|
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In recent weeks the strains in the government debt markets of the Eurozone’s member countries have escalated to a new and more dangerous level. Concerns over possible sovereign defaults have spread from those peripheral countries—Greece, Ireland and Portugal—which have already required external financial support, to larger, core members of Europe’s single currency.
Between early April and early July, five-year credit default swap (CDS) spreads on Italian and Spanish government debt jumped by 2 percent a year, nearly trebling in Italy’s case. It now costs nearly 3 percent a year to insure against the default of Italy for five years, and around 3.5 percent a year to insure against Spanish default. Even France, previously relatively untouched by Eurozone contagion, saw a doubling of its CDS spread over the same period, with default insurance now costing over 1 percent per annum.
Investors in exchange-traded funds that track indices of European sovereign debt face one obvious concern, relating to the composition of their benchmarks. An index that allocates higher percentage weights to the debt of the Eurozone’s perceived “problem” countries is undoubtedly riskier—and will pay investors a higher interest yield to compensate for that risk.
However, there’s a secondary and arguably no less important type of risk facing investors in European ETFs, particularly as European banking systems come under pressure. That’s the question of ETFs’ structure and the counterparty and collateral risks which they incur.
To illustrate these two levels of risk, in this article we’ve taken a sample of seven ETFs that track very similar benchmarks. All the ETFs aim to reproduce the returns of short-maturity European government bond indices (i.e., containing bonds with over one, but less than three years to maturity). The survey includes all European ETFs of this type that have over €100 million in assets. After describing the funds we look, in turn, at the two types of risk that we’ve just described: index-related and structural.
Short-Maturity Eurozone Government Bond ETFs
Index-Related Risk Exposures
The investment exposures of these seven short-maturity Eurozone government bond ETFs are determined by their underlying indices’ country weightings. These are illustrated in the bar chart below.
The German, French and Italian bond markets constitute the most significant weightings in these indices, collectively adding up to two-thirds or more of the benchmarks. Spain, Belgium and the Netherlands also command sizeable positions, while weightings in other countries’ government bond markets—including those of Ireland, Portugal and Greece—are typically in the low single figures.
The single most noticeable difference between the indices used by the seven ETFs in the survey is that between the concentrated nature of the Barclays Capital index tracked by iShares’ ETF, IBGS (which allocates a 40 percent-plus country weight to Italy, for example) and the more diversified nature of the iBoxx and EuroMTS indices that are used by the other six ETFs.
There are other, more subtle differences too. Markit’s iBoxx indices set a minimum ratings requirement for membership, and so Portugal’s recent downgrade to below investment grade means that the country (and its bonds) will be expelled from the iBoxx indices at the end of this month. EuroMTS, by contrast, sets no such ratings requirement, explaining the continuing presence of Greece in its 1-3 year benchmarks (albeit with a small, 2 percent weighting).