Slim Pickings for AAA-Rated Government Bonds

As France faces another downgrade to its government bonds, investors in ETFs tracking AAA-rated eurozone government debt may find their investment universe has shrunk

Jose Garcia Zarate 23 November, 2012 | 5:55PM
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This week the rating agency Moody’s announced it had downgraded French government bonds from the top-quality AAA rating to the one-notch lower rating, Aa1, with a negative outlook.  Moody’s decision followed in the steps of S&P, which stripped French government bonds of their prized AAA qualification in January.

As of this writing, Fitch is the only rating agency still classing French government bonds under the AAA umbrella. However, Fitch’s rating outlook for France was moved from stable to negative back in December 2011. There is a distinct risk that Paris might be in for a “full-house” of sovereign rating downgrades.

With two downgrades already in the bag, investors in exchange-traded-funds (ETFs) that track indices measuring the performance of the eurozone AAA-rated government bond market are probably wondering whether they will soon be invested in “de facto” German government bond ETFs. Indeed, a rational investor would assume that French government bonds can no longer be part of those indices. If so, the statistical void left by France would have to be redistributed amongst the remaining AAA bond markets, with Germany as the overwhelmingly dominant force against the much smaller Dutch, Austrian and Finnish elements.

While it is fair to infer that investors in AAA-rated government bond ETFs are essentially seeking security, it would be wrong to assume they would be happy putting their money in pseudo-German-only investment vehicles. For a start, seeking safety does not necessarily mean forfeiting all possibility of yield, which is what one would do by going German in the current environment. In fact, investors in the AAA-rated vehicles have enjoyed a bit of yield pick-up courtesy of exposure to non-German (i.e. mainly French) government bonds. But besides that, a considerable swathe of investors simply refuse to see France as anything else than top quality, irrespective of what the rating agencies say.

What should you do at this point if you are invested in a eurozone AAA-rated government bond ETF and you still want exposure to France? Well, for most the answer would be “keep your money where it is”. Over the years that I have been with Morningstar, one of the key messages I have always stressed to ETF investors is the importance of understanding the index an ETF is tracking. And this is one of those situations where knowing your index inside out would prevent you from making the wrong decision.

In our Morningstar ETF database, we find a total of eight ETFs tracking AAA-rated eurozone government bond indices, which are displayed in the table below. These ETFs are marketed by Lyxor, db X-trackers and Amundi. Each provider has opted to reference their ETFs to a particular index family: EuroMTS Eurozone AAA Macro Weighted Government indices for Lyxor; iBoxx EUR Sovereign Eurozone AAA indices for db X-trackers; and EuroMTS Eurozone Highest-Rated Government Bond indices for Amundi.

ETFs Tracking AAA-Rated Eurozone Government Bond Indices

Ticker TER  Replication Domicile
Amundi ETF GovBdHghstRtd EuroMTSInGr 1-3  AA13 0.14  Synthetic France
Amundi ETF GovtBdHghstRtd EuroMTSInvstGr  AM3A 0.14  Synthetic France
db x-trackers II iBoxx EUR SovErznAAA 1C  XBAT 0.15  Synthetic Lux.
db x-trackers II iBoxx EURSvErzAAA1-3 1C  X13A 0.15  Synthetic Lux.
Lyxor ETF EuroMTS AAAMacroWeightedGovtBd  MAA 0.17  Synthetic France
Lyxor ETF EuroMTS AAAMcroWghtdGovt1-3Y C  MA13 0.17  Synthetic France
Lyxor ETF EuroMTS AAAMcroWghtdGovt3-5Y C  MA35 0.17  Synthetic France
Lyxor ETF EuroMTS AAAMcroWghtdGovt5-7Y C  MA57 0.17  Synthetic France

According to the rules governing EuroMTS indices tracked by the Lyxor and Amundi ETFs, eligible countries must have “no less than two AAA ratings” from the three main rating agencies (e.g. S&P, Moody’s and Fitch). In principle, this would mean that France would be out. However, another rule clearly specifies that these particular indices must be comprised of a minimum of five issuing countries and where a credit rating downgrade for an eligible issuer would lead to the number of eligible countries falling below such minimum, then the issuer in question would remain in the index until a new issuer becomes eligible to replace it. In short, France will remain in the AAA-rated EuroMTS indices as: a) otherwise the number of issuing countries would be below the minimum and b) it is highly unlikely to foresee any of the remaining eurozone countries being upgraded to AAA. Morningstar has confirmed with EuroMTS that this is correct. 

If you are invested in the db x-trackers AAA-rated eurozone government bond ETFs, then the situation may be different. Eligible bonds for the iBoxx indices these ETFs track must have an “average iBoxx rating” of AAA, which is calculated as the average of the ratings from the three main rating agencies. Before the Moody’s downgrade, France still made it as AAA. However, as Markit has also confirmed with Morningstar, the average iBoxx rating for French bonds has now been scaled down to AA. This implies that French bonds would be stripped out of the iBoxx AAA-rated Eurozone government bond indices at the next rebalancing (i.e. at the end of the month). If so, the db X-trackers Eurozone AAA-rated government bond ETFs would become de facto German government bond ETFs, unless of course db X-trackers decides to change the index to the iBoxx EUR Sovereigns AAA-AA (yes, there is such an index!) in which case, you’d still get exposure to France, but would also gain exposure to Belgium.

Investing using ETFs is a straightforward way of gaining exposure to a large array of asset classes. However, you still have to do your research. Chief in this is understanding the index an ETF tracks. Morningstar’s collection of ETF due diligence reports has specific sections dedicated to unravel all the main aspects of index construction and they can help you in your investment decision process.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Jose Garcia Zarate

Jose Garcia Zarate  is Associate Director of Passive Strategies Research for Morningstar Europe

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