PIGS get slaughtered - EXX6

"Drawing his own conclusion" - the fate of non-core euro sovereign debt?

The iShares Euro Government Bond 15-30 ETF (IBGL.LSE) was added to the CCI portfolio last September, and has been a solid perfomer since, up some 14% on the average purchase price of £116.96 (along with a nice divi).

I believe that the rationale for my purchase of IBGL remains strong, viz.:

- deflation is more likely in the euro zone than anywhere else;
- the ECB will remain "behind the curve" of interest rate reductions and money-printing;
- the euro will be a relatively strong currency;
- long-dated government bonds will be very attractive assets.

IBGL, which represents a bundle of long-dated bonds issued by all euro-zone governments, is a simple way to play this trend.

However, the reality is that all euro-zone debt is NOT created equal, and I am increasingly worried about the PIGS - Portugal, Italy (or Ireland), Greece and Spain.

Back when the euro was launched (and, having been intimately involved in the project on behalf of a major European bank, I remember it well), there was a lot of discussion regarding "convergence" - how the different markets for European financial instruments would converge in terms of risk rating, now that all were priced in a single currency. This was, of course, one of the aims of the project - to help EU capital markets aquire the same depth and liquidity as those in the US. And, for a while, it did indeed seem to be the case that euro-zone sovereign debt prices were converging - that a German government bond of a given maturity was being regarded as the same thing as an Italian government bond of similar maturity.

Which is, of course, nonsense, when you consider it. Bonds issued by the First Appalachian Savings and Loan are denominated in the same currency (US dollars) as those issued by, say, Warren Buffet's Berkshire Hathaway, yet no one would suggest that they should be rated similarly for default risk. Just because Italy has joined the euro does not make it as good a credit risk as Germany.

And, as I have noted before, it is highly likely that the Credit Crunch will, at some point, force at least some of the PIGS to abandon the euro, as they reach for their traditional response to economic crisis - just print more money! Then, they can simply repudiate existing euro debts by announcing that, in future, they will be repaid in "new lira", at an arbitratily fixed exchange rate (which will bear no relation whatsoever to the prevailing market rate).

It's commonplace to read (eg, here) that such a scenario would mean "the end of the euro", but actually I very much doubt that. The core of the euro - in truth, the core of the whole EU project - is the alliance between France and Germany. All else is peripheral, and I very much doubt that either of those two states will ever be forced into such action.

For Germany, of course, where the lessons of the Weimar experience are still very clear, such a move would be anathema. It is also unlikely to be necessary, given the relative strength of the German economy.

So, the point I am coming to, in practical terms, is that IBGL is far from ideal. Long-dated euro government debt is, I think, I great investment for deflationary times, but it should, ideally, be the right government debt, rather than a bucket like IBGL. Ideally, it should be German government debt ... why buy a FIAT when you can have a Mercedes?

Well, on investigation, you CAN buy a Mercedes, relatively easily, if your broker can trade European shares. Barclays iShares also offer German-only euro government bond ETF's, traded (naturally) on the Deutsche Borse. The long-dated one (which I think offers best upside potential) is the iShares eb.rexx Government Germany 10.5+ (DE), ticker symbol EXX6. To find out about it, you have to navigate to the iShares German site.

So, I have today dumped IBGL at £132.42 and bought a similar value amount of EXX6, at €127.54 (about £111.13).