Sovereign risk has been shaping pricing dynamics in the eurozone government bond market since the onset of the global financial crisis and particularly so after the collapse of Lehman Brothers. Despite some relevant political moves (e.g. approval of the EU-IMF-funded Greek rescue package and of the EUR 750 billion European Stabilisation Fund) aimed at restoring some sense of calm, market concerns about the financial health of some eurozone country members are still at the top of the agenda.
Ireland, not so long ago praised for bold and speedily implemented budgetary measures, is again in the firing line, with market participants running for the hills on the sudden realisation that offloading bad bank debt onto an off-balance-sheet, purpose-built vehicle (e.g. NAMA) did not mean that the debt actually disappeared.
As a result of ballooning borrowing needs to finance the banking rescue, Dublin could therefore be the first to put the European Stabilisation Fund to the test. And if it does, it would be a crucial test, providing a definitive answer to those sceptics arguing that the Stabilisation Fund is a theoretical structure with little chance of ever coming to real fruition.
This general backdrop bodes well for continued pricing tensions in the eurozone sovereign bond market and, by extension, in all financial products that track them, such as ETFs. This begs the question, can investors wanting to use ETFs reconcile the objectives of gaining access to the eurozone government bond market, while minimising sovereign risk exposure? The answer is yes, they can. However, to do so calls on investors to undertake thorough research of the large array of eurozone government bond ETFs currently in the marketplace.
The key issue here is to identify which index the ETF is aiming to replicate; to then carefully analyse the rules governing its construction, and ascertain the level of exposure it provides to those eurozone government issuers deemed the riskiest. It may be time consuming, but would-be ETF investors should never underestimate the importance of understanding indices, for these are ultimately what they are gaining exposure to.
Identify Your Pain Threshold...
But even ahead of embarking on index choice, one has to identify the issuers most at risk. Although not the only one, credit default swaps (CDS) have become the market measure of choice to gauge sovereign risk.
The accompanying graph shows how perceptions of sovereign risk have changed since the start of the crisis. We have gone from a pre-crisis situation where market participants happily adhered to the notion of almost perfect substitution between sovereign bonds of eurozone issuers, to one where government paper from the so-called peripheral issuers carry a sizeable risk premium vis-à-vis the mighty German Bund.
As we write, measured in CDS terms, Greece, Ireland and Portugal are the three eurozone issuers seen most at risk of default. The big eurozone peripheral beasts of Italy and Spain follow behind. We would also add Belgium, given the unholy combination of a large public debt burden and increasingly common inability to form--let alone sustain--functioning governments.
...Then Search for the Index that Best Fits It
Once the sources of sovereign risk are identified, ETF investors can then choose the index that best fits their personal perceptions.
There are four main index families used by European ETF providers: EuroMTS, iBoxx, Barclays Capital and eb.rexx. Each branches out into a large number of subsets offering varying degrees of exposure to perceived sovereign risk.
A common feature of each is that they statistically weigh countries to represent the size of its outstanding debt relative to the eurozone's aggregate. This means that the three riskiest sovereigns (e.g. Greece, Ireland and Portugal) have small weightings. This is important, as in some cases we find that negative performances from the small peripheral issuers can be offset by the higher weighting given to core issuers like Germany, France and the Netherlands in the indices. Investors with a broader approach to sovereign risk-aversion are likely to be more concerned with exposure to the likes of Italy and Spain, with the former generally topping all indices’ statistical weighting tables on account of its status as largest issuer and holder of the biggest stock of outstanding debt.
EuroMTS does not set a minimum credit rating criterion for index constituents, meaning that non-investment-grade-rated Greece continues to be represented in its eurozone global and broad indices. Meanwhile, both iBoxx and Barclays Capital do discriminate issuers on credit rating, requiring an investment grade rating from at least one of the three main rating agencies--currently making Greece ineligible.
Looking at the broader eurozone government bond indices covering the whole maturity spectrum from EuroMTS (e.g. Global and Broad), iBoxx (e.g. Euro Benchmark and Euro Liquid Sovereign Diversified) and Barclays Capital (e.g. Total), we find that combined exposure to eligible risky sovereigns hovers in a 43%-47% range. ETF investors wanting to minimise sovereign risk exposure can do so by targeting indices tracking specific issuers or applying strict rating criteria for eligibility. In the first category we find the popular eb.rexx Germany index family, measuring the performance of the German government bond market. In the second category, we find some indices only following AAA-rated sovereigns (e.g. EuroMTS AAA), while others exclude the smaller issuers (e.g. Barclays Capital Term and iBoxx Euro Liquid) though still include Italy and Spain.
Perceptions of sovereign risk are ultimately a personal choice, and those of the view that concerns about the eurozone are overdone can also find indices and ETFs affording a high, sometimes total, level of exposure to non-AAA sovereigns. But for all investors the message is the same; before putting your money in a eurozone government bond ETF, identify your personal sovereign risk threshold and then search for the index that best fits it.
This article first appeared in Investment Week.
