How to Profit Off European Debt

Mike is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Popular wisdom tells us that European debt, such as government bonds, are risky at this time. Yet recent news stories indicate very much the opposite. Many hedge funds that bought Greek government bonds have made a profit on the deal. One hedge fund, Dart Management, reportedly bought Greek debt at 60 to 70 cents on the dollar and made 100 cents on the dollar when Greece made a bond payment in May.

The Japanese government is planning to buy bonds issued by the European Stability Mechanism (ESM) and various European governments. Interest in European debt is high, and when the ESM held its first auction of €1.9 ($2.5) billion worth of debt on Jan. 8, Bloomberg reported that investors placed bids worth £6.2 ($8.67) billion. Even notoriously conservative U.S. value investors such as Seth Klarman are joining the rush to get in on the European debt market.

Some European bank and government debt was selling at prices 70% below face value and with potential returns like that, along with the European Union’s willingness to buy back debt; some of the debt is an attractive investment. Not surprisingly, many people are now wondering if exchange traded funds (ETFs) that specialize in European debt have become a good income investment.

European Debt ETF Performance

A whole crop of European debt ETFs have appeared during this crisis. How have these funds performed, and will they really give average people the kind of returns some hedge funds have received from Euro debt?

The Wisdom Tree Euro Debt Fund (NYSEMKT: EU) , which invests in the debt of almost every EU member, posted modest gains the last year. It fell to a low of $19.98 a share on June 9, 2012, but rose to $22.48 a share by Jan. 11, 2013. EU offers the advantage of being extremely stable because of diversification, but it doesn’t offer high gains. This ETF is extremely stable because its purchases are in debt from extremely stable countries, such as Germany and Finland. However, it is heavily exposed to France, which some observers think is in as bad a shape fiscally as Spain.

The most recent distribution from this fund was 22¢ on the dollar on Dec. 31, 2012. The Euro Debt Fund has had a 13.01% return for the last year, but a .95% loss for the past three years. An EU owner would have done better with an S&P index ETF because the S&P 500 returned 36.79%. Yet EU might do better in the future if it starts investing heavily in the brand ESM paper, which is backed by the entire European Union.

So what about an ETF that concentrates on bonds issued by Europe’s biggest success story, Germany? The Pro Shares German Sovereign/Sub-Sovereign ETF (NYSEMKT: GGOV) is composed of government debt from the Federal Republic. It buys debt issued by Germany’s federal government, German states, German banks, and German municipalities. The advantage to this ETF is that it invests in Europe’s most stable country and successful economy, so it is highly unlikely to have any losses.

The problem is that it hasn’t made much money lately; its total rate of return for the last year was 2.73%. The GGOV return was slightly less than a 10-year U.S. Treasury Bond, which had a 2.97% rate of return in 2012. The cheaper Wisdom Tree Euro Debt Fund had a far better rate of return with a little more risk.

Bargain Hunting in Basket Case Economies

Real bargain hunters will wonder about ETFs that invest in distressed European debt. The big money in recent months has been made in the paper issued by economic basket cases such as Greece, Spain, Ireland, and Italy. There are some ETFs that buy Southern European, including the PowerShares DB (Deutsch Bank) Italian Bond Futures ETN (NYSEMKT: ITLY).

Interestingly enough, ITLY’s share price went up by nearly $6 over 2012 despite vast amounts of bad news coming out of Italy. The ETF was priced at $18.64 a share in early January 2012 and trading at $24.26 a share on Jan. 11, 2013. It posted a total return of 21.06%, compared to 13.01% for EU and 2.73% for GGOV. Italian bonds certainly paid off for contrarian investors. 

Okay, if Italy pays off, what about another European economic disaster area, namely Spain? The problem is that there isn’t any U.S. ETF that trades in Spanish debt, although there is such an ETF, iShares Barclays Spain Treasury Bond. It only trades in London and has done fairly well, posting gains of around 8.13% between June 2012 and Jan. 4, 2013.

There appear to be no ETFs that invest exclusively in Greek or Irish government debt, although Europe wide bond funds, like the Wisdom Tree Euro Debt Fund, hold some Irish and Greek securities.

European debt ETFs can pay off for those who are willing to take a risk on them. The best deal for Americans interested in European debt is the Wisdom Tree Euro Debt Fund. It has a respectable return and offers fewer risks than are associated with ITLY. 

mthiessen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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