While not altogether surprising, S&P’s decision to downgrade the ratings of nine eurozone countries--including the loss of the prized AAA by France and Austria--is likely to reverberate in financial markets for some time to come. For the investment community at large it should be expected to heighten the levels of uncertainty surrounding the resolution of the eurozone sovereign debt crisis, thus furthering the general safe haven-seeking theme that has shaped investment flows for much of the last six months. But the ratings bloodbath also has important implications for the structure of some eurozone government bonds exchange-traded funds (ETFs), namely the suite of AAA-focused ETFs currently in the marketplace.
Against the backdrop of the eurozone sovereign debt crisis, some European exchange-traded product (ETP) providers (e.g. Lyxor, Amundi) have been attempting to meet investor demand for low risk and generous-yielding strategies with a set of funds encompassing the full universe of AAA-rated eurozone government bonds. The investment thesis underpinning these funds was simple: exposure restricted to eurozone issuers with top ratings from all three major rating agencies (e.g. S&P, Moody’s and Fitch) plus a good measure of yield pick-up vis-à-vis the German government bond market.
At the latest count we recorded five AAA-centric eurozone government bond ETFs in our database, all swap-based. The Lyxor EuroMTS AAA Macro-Weighted Government Bond (MAA) and the Amundi AAA Government Bond EuroMTS (AM3A), both tracking indices covering the whole maturity spectrum, and the suite of three Lyxor EuroMTS AAA Macro-Weighted 1-3y (MA13), 3-5y (MA35) and 5-7y (MA57), launched in November and catering for maturity-targeted investor’s needs. (Note – the Lyxor EuroMTS AAA Macro-Weighted Government Bond ETF was marketed as Lyxor EuroMTS AAA Government Bond until last November when it changed its EuroMTS reference index from classic market capitalisation to fundamental weighting.)
The fortunes of the two longer-running funds in this category (e.g. MAA and AM3A) were different over the course of 2011. According to Morningstar Direct data (see table), both ETFs returned a healthy 7.0% y/y, but while the Amundi fund saw net inflows of EUR 29.5 million over the year, the Lyxor ETF experienced net outflows of EUR 253.4 million, though still remaining market leader in this particular market niche.
Upon S&P’s ratings downgrade of both France and Austria, all these funds will see a substantial rebalancing of their portfolios to comply with the strict ratings criteria on which the reference indices are built. The combined statistical weight of France and Austria in these indices (e.g. 48% in the case of the market-capitalisation EuroMTS AAA and 38% for the fundamentally-weighted EuroMTS AAA Macro Weighted) now has to be redistributed among the three remaining countries still rated AAA from all three agencies. A back-of-the-envelope calculation shows that Germany’s statistical weight could increase to 73%-80% of the basket from the current 38%-47% (note – the lower end reflects Germany’s bond market capitalisation value while the upper-end is macro-adjusted).
Furthermore, as the below graph shows, the exclusion of France and Austria severely undermines the yield pick-up proposition vis-à-vis Germany. This potentially leaves investors to mostly rely on capital gains from Dutch and Finnish government bonds – both against Germany and non-AAA eurozone countries – now that their status as almost near-perfect alternatives to Germany has been enhanced by S&P’s move. The problem here is that room for appreciation of the Dutch-Finnish contingency was already fairly limited ahead of the S&P event, as the comparative evolution of spreads against Germany over the second half of 2011 shows.
In sum, upon the rebalancing of indices and, thus, these funds’ reference portfolios come February, these AAA-centric ETFs are unlikely to differ much from the purely German government bond ETFs already offered by other providers (e.g. iShares, Comstage, ETFlab). At a time when safety is primed above returns (e.g. recall investors paying Germany for holding their assets) this may not be seen as much of an inconvenience, not least if one takes this restricted core of AAA-rated countries as an accurate depiction of what an eventual redrawn eurozone may look like in the future. The risk – a tail risk for some, perhaps – is that Germany’s comparatively enhanced rating status puts it in line to shoulder a larger share of any eventual euro stabilisation mechanism. If this were to happen, then full exposure to Germany and her perfect substitutes might not look the near risk-free investment idea it now appears. Only time and the Greeks will tell.
