Trading Government Defaults

How can you profit from the coming government meltdowns?

 

After a year of aggressive growth in asset prices, credit default swaps on several nations’ government debt widened dramatically in the course of last week’s reduced trading period. Wednesday, Dubai World—a company owned by the government of
Dubai—effectively announced that it was defaulting on its short-term debt obligations, sending CDS contracts on the Arab Emirates zooming up some 120 percent.

Investors immediately looked for the next shoe to drop, sending CDS contracts on countries like Italy, Greece, Britain and the
U.S. surging as well.

Can the average ETF investor take advantage of a potential string of (near-)defaults and subsequent bearishness to gain a trading advantage?

Unfortunately, there are still no ETFs available yet in the
U.S. that give an investor the opportunity to speculate on the rising and falling value of CDS contracts.

A company called ETSpreads has filed for four CDS-linked ETFs in the
U.S., although they would be tied to corporate CDS swaps and not sovereign debts. In
Europe, corporate CDS ETFs swaps exist. No one has yet tackled the market for sovereign CDS contracts.

The good news, however, is that with the huge growth in trading volumes this year have come a plethora of new exchange-traded products, including various country-specific, asset class-specific and long/short strategy funds, which can offer a back-door way to play this crisis.

Beware Of
Greece

At the front of the line in terms of countries likely to default on their national debt is
Greece. Monday, it was rumored that the country was seeking to sell an additional 25 billion euros ($16.7 billion) of government bonds to Chinese banks to shore up its short-term cash deficit, after five-year CDS on the country’s bonds spiked more than 15 percent last week, surpassing Turkish CDS for the first time. Rumors and analysis are rampant (here and here).

If the situation deteriorates further, investors might want to keep an eye out for a Greek-Turkish ETF combo, which is due to be launched in early 2010 (see story here). In the meantime, iShares MSCI EMU Index Fund (NYSEArca: EZU) has been capturing some of the volatility created by Greece and Italy, since it is substantially invested in Spain and
Portugal. The latter two countries are closely tied to the former two in terms of trade through their traditional alliances via the PIGS (Portugal, Italy, Greece and
Spain) categorization.

As a cheap-and-dirty way to bet against trouble in Italy, where debt-to-GDP is forecast to rise to 127.3 percent by 2010, a small short position on the iShares MSCI Italy (NYSEArca: EWI) might make sense. EWI has more than doubled this year too, giving it ample room for a sell-off in the event of jitters created by a government default.

There are various Middle Eastern ETFs, among them the Market Vectors Gulf States Index ETF (NYSEArca: MES) and the broader WisdomTree Middle East Dividend Fund (NasdaqGM: GULF). The problem with short-selling these ETFs is that, in contrast to EWI, they haven’t risen very much this year compared with other assets (5 percent), making them unattractive bets to wager against.

Interestingly, neither fund has moved that aggressively since news of the
Dubai troubles hit. Both are down, of course, but about on par with other emerging market ETFs. The performance of the funds did, however, presage the troubles: Since Oct. 26, the S&P 500 SPDRS (NYSEArca: SPY) has outperformed MES by 15 percent.