As the tumultuous and historic year of 2008 draws to a close, one sector of the European exchange-traded fund market has boomed: fixed income. Even as equities have wilted, the fixed-income ETF sector has grown, reaching 27.4% of all European ETF assets by end-November, up from 16% at the beginning of 2008.

There are a number of factors driving this ascendance. One, of course, is simple performance: Bonds have performed better than equities (or commodities, for that matter), so their share of total assets under management has risen sharply.

Bonds have also been the asset class of choice for many investors, as the result of a flight to safety from riskier assets such as equities, and as investors flock to any safe instrument offering a fixed return.

Yet, below the surface, the performance of the different bond market sectors has been remarkably diverse. This feature reviews the different European bond ETF categories, their 2008 year-to-date price return (i.e., excluding interest income), and the year-high NAV and year-low NAV (to give a feel for the variability of returns). The gross redemption yield as at 24 December, where available, is also given.

We have selected a broad cross section of European ETFs from the given fixed-income categories, excluding money market funds, whose returns are largely predictable (reflecting the average return on cash deposits during the year), and also inflation-linked bonds, which we covered in a recent feature.

The ETFs chosen in the table have been selected as a representative sample of the different areas of the bond market, but are not meant as an exhaustive list.

Government Bond ETFs

Government bond investors enjoy a variety of choices from a number of different providers, including funds focused on different sovereign markets and different spots on the yield curve.

Bonds issued by the leading Eurozone sovereigns, the US and UK governments, added another leg to a multiyear bull market in 2008, as the rapid deterioration in economic conditions led to dramatic cuts in official interest rates.

From the beginning of 2008 to 24 December, the European Central refinancing rate fell from 4.25% to 2.50%, the U.S. Fed Funds rate fell from 4.25% to a target band of 0%-0.25% and the UK base rate fell from 5.5% to 2%.

For the ETFs in the table, the longer-maturity funds provided the highest price return, benefiting from the increased sensitivity to interest rates of long-dated bonds. The EasyETF iBoxx Liquid Sovereigns Global, Lyxor ETF EuroMTS 15+ Year, db x-trackers iBoxx Euro Sov. Eurozone 25+, and iShares $ Treasury Bond 7-10 ETFs all gave double-digit price returns (more if interest income were to be included).

At the same time, the yields on offer from these government bonds are now much less attractive to investors. The iShares short-maturity (1-3 year) Treasury ETF now yields a mere 0.66%, and only one of the other funds in the table yields over 4%. Even if yields stay low, it will be difficult, if not mathematically impossible, for these ETFs to repeat their 2008 performance in 2009.

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?