The first step towards the resolution of a problem is to acknowledge its existence. This is precisely what the ECB President Mario Draghi did on 26th July when he candidly admitted that cross-country sovereign bond spreads in the eurozone were factoring in “convertibility” risk. In other words—as highlighted previously in the article Eurogeddon—financial market operators selling Spanish and Italian government bonds in the last couple of months were not acting on fear of a sovereign default of either country within the single currency area, but rather on expectations that such default would come as a consequence of a disintegration of the euro and a return to national currencies. In that situation, a monetary policy targeted to a single currency area in which investors no longer believe simply ceases to be effective, which explains why Mr Draghi came out guns blazing on 26th July: “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough”.
This was gutsy stuff from the ECB President. And judging from the market reaction to his words, Mr Draghi was clearly given the benefit of the doubt. This is something of a double-edged sword. The ECB remains a credible agent, which is essential for a monetary authority. However, gutsy words will have to translate into gutsy deeds so as to avoid a total collapse of confidence. What form these deeds might take is debatable, but their key objective is very well defined: to do away in a permanent manner with the notion of foreign exchange risk in the formation of eurozone cross-country government bond spreads. If achieved, this should have significant market implications.
An 'FX Risk-Free' Eurozone?
The total removal of “FX risk” implies a reduction in the yields of the eurozone peripheral bond issuers, and an increase in those of the so-called “core” issuers, to bring cross-country spreads to an equilibrium level solely reflective of sovereign default risk within the same monetary area. One can probably reach a decent enough approximation to such an “FX risk-free” equilibrium level just by interpretation of market trends. The “FX factor” became the main driving force behind eurozone bond spreads from the latter end of the first quarter 2012. This is the time when the soothing effects of the ECB’s 3y LTROs had fizzled out and the market finally gave up on eurozone politicians. At that point, 10y Italian and Spanish bond yields were around 5% and those of Germany were around 2%. This was the same level at which these bonds traded after the ECB’s peripheral bond-buying intervention in August 2011. Hence, it seems reasonable to take 300 basis points (5% minus 2%) as our “FX risk-free” equilibrium. Based on valuations ahead of the ECB meeting of on 2nd August, 10y Spanish and Italian bond yields would still need to come down by 150 and 100 basis points, respectively, while 10y German bond yields would need to increase by around 50 basis points. The decrease in peripheral yields for shorter-dated maturities could be of a higher magnitude as short-dated debt will have been more impacted by the aforementioned FX risk.
A Tactical Investment Opportunity
If you think the ECB is determined to put its money where its mouth is and, more importantly, stick to the plan, then there clearly is a tactical opportunity to benefit from a eurozone peripheral debt “rally”. This would call for a temporary overweighting of exposure to these markets in your portfolio, which can be done with exchange-traded-funds (ETFs). The bulk of eurozone government bond ETFs in the marketplace offers exposure either to the broad investment-grade or the restricted AAA-rated universe of issuers. However, there are a few products exclusively targeting the unloved periphery, either as a group or individually. The longest running is the Amundi Government Bond Lowest Rated EuroMTS Investment Grade ETF (X1G). This swap-based fund charges a total expense ratio (TER) of 0.14% and offers exposure to Italy, Spain, Ireland and Belgium. The combined exposure to the first three issuers is around 70% of the index, while Belgium, which has been spared the FX risk factor, accounts for the remaining 30%.
ETFs offering exposure to individual eurozone government bond issuers other than Germany are a fairly new addition to the marketplace. That ETF providers felt compelled to launch single country government ETFs only serves to underline how the idea of perfect substitution between government bonds of eurozone countries is dead in the water; quite possibly for good. Irrespective, these ETFs come in very handy to roll out the kind of tactical investment idea expressed in this article. The db x-trackers MTS ex-Bank of Italy BTP ETF (XBTP), launched in January 2012, is a swap-based fund carrying a TER of 0.20%. Meanwhile, since May 2012, iShares provides a full deck of single eurozone country government bond ETFs, including the iShares Barclays Spain Treasury Bond (IESP) and the iShares Barclays Italy Treasury Bond (IITB). These physically replicated funds each carry a TER of 0.20%.
