€9.4 billion is currently invested in diversified Eurozone government bond ETFs, forming a significant part of the overall European fixed income ETF sector. These ETFs track a diverse range of indices, provided by iBoxx, EuroMTS, Barclays and JP Morgan.

The funds have been one of the best-performing segments of the European ETF market over the last 18 months, as investors sought a safe haven from the equity markets, and as interest rate declines gave capital gains to those holding bonds. Until recently, the only real decision a fixed income ETF buyer had to face was where on the yield curve, i.e., the maturity spectrum—to hold bonds.

But, since the autumn, there has been another question to consider—sovereign credit risk. Until the end of the third quarter, most Eurozone sovereign issuers had bond yields that differed little from each other at a given maturity, indicating that investors judged them almost equally creditworthy. Since then, as recessionary pressures have intensified, and several European governments have intervened to try and prop up their domestic financial systems, the credit spreads of individual sovereigns have diverged wildly, and are continuing to do so.

The chart below illustrates this, by showing the 5-year sovereign credit default swap ("CDS") spreads of 11 of the 16 euro member states (the major countries—we've excluded Malta, Luxembourg, Cyprus, Slovakia and Slovenia), plus the UK (which is not a euro member), from the beginning of June last year to the end of February 2009. The CDS spread measures the cost of insuring against the default of the sovereign issuer.

From a status quo in which all Eurozone government issuers had credit default spreads within a range of 0.5% per annum of each other, the differential between the most and least risky has risen to the current 3%. Ireland now trades at around 4% per annum for a five-year CDS, whereas even German sovereign debt requires a default insurance premium of approaching 1%.

From the point of view of the credit derivatives markets, the riskiest euro member governments were, in declining order and at the end of February: Ireland, Greece, Austria, Italy, Spain, Belgium, Portugal, Netherlands, France, Finland and Germany.

There has been increasing speculation that one or more countries could be forced to leave the single currency, although it is quite unclear what the mechanism might be to do so. Plans to issue EU-wide bonds to help support the weaker countries have been mooted, then shelved after criticism by the head of the German sovereign debt agency. Meanwhile, Joaquín Almunia, European Union Economics Commissioner, spoke recently of a plan to rescue any of the 16 single-currency member countries in the case of necessity, although he avoided going into detail.

However the current tensions are resolved, it's clear that investors who have bought, or who are considering buying bond ETFs based on Eurozone government bond indices, need to pay close attention to the composition of the indices, and the weightings of the respective government issuers within them.

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