The Barclays Euro government indices are the least-diversified of the European government bond indices under review, with some individual country weightings above 40%, and only five countries represented. There is also a big difference in the weightings allocated to individual countries by different maturity band—note Italy's weighting, which varies from 15% to 42% in the indices under review. Germany, France and Italy, taken together, represent around 90% of the index in each case.

The JP Morgan GBI EMU index weightings are broadly similar to those of the EuroMTS and iBoxx Euro Sovereign indices, except that the index series does not extend beyond 10 years in maturity.

How Are Sovereign CDS Spread Differences Reflected In Bond Yields?

It's worth pointing out that the CDS spreads shown in the chart at the beginning of the article do not automatically translate into an equivalent bond yield differential between the countries concerned, for two reasons. First, CDS spreads are typically quoted for a notional five-year maturity, whereas in the case of longer- or shorter-dated bonds, reference should be made to the cost of default insurance at that term. Second, there is the possibility of divergence (basis risk) between CDS spreads and bond yield spreads. Nevertheless, CDS spreads should give a pretty accurate reflection of the real funding costs faced by Eurozone governments. To give an example, Ireland's 10-year bond yield spread over German bonds last week traded at around 250 basis points, a fairly similar spread to that existing between the two countries' CDS.

How Might ETF Investors Be Affected?

In the worst-case scenario—that of the exit of a country or countries from the euro, or even a default—investors in ETFs tracking indices with high weightings in the countries concerned would face significant losses. The Eurozone bond indices would have to be rebalanced, eliminating the countries affected, but by this time, investors would already have suffered a hit.

On the other hand, a resolution of current euro tensions would lead to outperformance by ETFs with large holdings of higher-yielding governments. As things stand, this seems like an outcome with a fairly limited chance of occurring.

How To Hedge

Those set up to trade in credit derivatives can hedge the sovereign default risk of individual governments by using the CDS market, an option that is not open to many investors. Since the only EU sovereign country bond ETFs available are those tracking UK and German government issues, there's no way of building an ETF portfolio of selected European government bond markets by yourself. If sovereign yield spreads continue to be high and volatile, new ETFs allowing investors to differentiate between individual European government issuers would seem a highly desirable product.

Paul Amery is the managing editor for IndexUniverse.eu. He can be reached at This e-mail address is being protected from spambots. You need JavaScript enabled to view it .

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