Corporate Bonds

The corporate bond ETF sector has shown a very different picture in 2008, reflecting growing fears of default.

All three iShares corporate bond ETFs, covering US dollar, euro and sterling issues, have given a negative return for the year to Christmas, with the sterling and US dollar funds showing a remarkable 25-point range in prices during the period. In fact, all these ETFs have recovered significant ground from their lows, set in October, even though they have not returned to positive territory for the year. To give a feel for the roller-coaster ride these ETFs have endured, the iShares $ corporate bond ETF net asset value fell from 95.71 on 12 September (the Friday before the weekend of the Lehman bankruptcy) to 79.40 on October 13, before recovering to 94.04 on 24 December.

Yields on the three ETFs still present a pickup of around 3-5% over government bonds of similar maturities, with the iShares Sterling corporate bond ETF offering the highest yield to redemption.

In all cases for the corporate bond sector, it's been a story of a dramatic widening in spreads during the year. Two other sectors of the fixed-income ETF market tell a similar story.

Credit And Emerging Market ETFs

First, credit ETFs, which track indices formed from the credit derivative (CD) spreads of corporate issuers, have also given negative returns for the year, with the lower-quality issuers (represented by the Crossover and HiVol indices) showing the most dramatic widening in spreads. At its recent trading levels of over 1,000 basis points, the iTraxx Crossover index is implying that on a cumulative five-year view, around half the 100 index constituents will default on their debts.

Second, emerging market debt ETFs have suffered a very difficult 2008, particularly in the second half of the year, as concerns over issuer default started to escalate.

While both the iShares and db x-trackers emerging market debt funds were launched during 2008, and therefore no returns for the year to date are available, the dramatic moves of over 30% from year-high to year-low took place in less than two months, as prices crashed in September and October.

Emerging market debt remains in the doldrums as an asset class, with huge worries about credit quality impacting prices. According to CMA DataVision, the likelihood of default over the coming five years for sovereign debt—as derived from current credit derivatives quotations—ranges from the near-certain (Argentina at 91% likelihood) to the highly possible (Indonesia at 44% likelihood). It puts other rates as follows: Ukraine (90%), Venezuela (89%), Pakistan (87%), Iceland (55%), Latvia (50%), Russia (46%) and Kazakhstan (44%).

Collateralised Bonds

Finally, an oasis of calm in the maelstrom of the 2008 debt markets—the European collateralised (covered) bond market, backed by mortgage and public sector loans.

Offering a steady, cash-plus return and yielding more than government bonds, this sector is so far untouched by the credit crisis. Will this remain the case in 2009?

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