The actual downgrade is probably more symbolic than any ill omen.  But it should make you wonder which other downgrades are coming for ETF products and for business entities and funds which have high exposure to weaker international credit.  Today’s S&P downgrade was to ‘Af’ from ‘A+f’ while the volatility rating remains unchanged at ‘S4′.

S&P noted, “We lowered the credit quality rating because of an exposure of approximately 11% of the fund’s total assets to ‘BBB’ rated bonds that remain eligible investments for the Global Treasury Ex-US Capped Index… The index includes government bonds issued by investment grade countries outside the U.S., in local currencies, that have a remaining maturity of one year or more and are rated investment grade or higher using the middle rating of Standard & Poor’s, Moody’s, and Fitch.”

Also noted, “Our credit quality and volatility ratings are based on our analysis of a fund’s eligible portfolio investments and strategy, historical return volatility, and management. The fund credit quality rating scale ranges from ‘AAAf’ (highest level of protection) to ‘CCCf’ (least protection).  The ratings from ‘AAf’ to ‘CCCf’ may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories.

This particular ETF has over $1.1 billion inside its funds.  If you track the PIIGS, 11.8% of the ETF is Italy, Greece is 4.32%, and Spain is 4.55%.  The fund’s fact sheet shows the average credit rating of its securities is “AA2″ and has a modified duration of 6.38.

Again, our concern here is the collateral fallout which could come up.  Having broad exposure like this will not kill an ETF, but there are many others out there with similar exposure.  Stay tuned.

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JON C. OGG

BWX seeks to replicate as closely as possible the price and yield performance of its benchmark index, the Lehman Brothers Global Treasury Ex-U.S. Capped Index. The Index tracks fixed-rate local currency sovereign debt of investment-grade countries outside the U.S.

As of August 31, 2007, there were 674 issues from 18 countries denominated in 11 currencies included in the Index. The Fund will normally invest at least 80% of its total assets in fixed-income securities that comprise its benchmark Index.

Jon C. Ogg
October 4, 2007