Short gilt ETFs in focus as Moody’s strips UK of AAA credit rating

Feb 23rd, 2013 | By | Category: Fixed Income

Moody’s has downgraded the government bond rating of the United Kingdom by one notch to Aa1 from Aaa. The rating agency becomes the first to strip the UK of its prized triple-A rating.

Short gilt ETFs in focus as Moody’s strips UK of AAA credit rating

Short gilt ETFs could rally following the UK downgrade.

The downgrade could represent an opportunity for traders looking to exploit potential price falls via short gilt exchange-traded funds (ETFs), which provide inverse exposure to UK government bond prices.

The drivers of downgrade were the continuing weakness in the UK’s medium-term growth outlook; the challenges that subdued growth prospects pose to the government’s fiscal consolidation programme, which is now anticipated to extend well into the next parliament; and, as a consequence of the UK’s high debt burden, a deterioration in the shock-absorption capacity of the government’s balance sheet.

At the same time, Moody’s explained that the UK’s creditworthiness remains extremely high because of the country’s significant credit strengths. These include a highly competitive, well-diversified economy; a strong track record of fiscal consolidation and a robust institutional structure; and a favourable debt structure.

The now stable outlook on the UK’s sovereign rating reflects Moody’s expectation that a combination of political will and medium-term fundamental underlying economic strengths will, in time, allow the government to implement its fiscal consolidation plan and reverse the UK’s debt trajectory.

Moreover, although the UK’s economy has considerable risk exposure through trade and financial linkages to a potential escalation in the euro area sovereign debt crisis, its contagion risk is mitigated by the flexibility afforded by the UK’s independent monetary policy framework and sterling’s global reserve currency status.

As reflected by the stable rating outlook, Moody’s does not anticipate any movement in the rating over the next 12-18 months. However, downward pressure on the rating could arise if government policies were unable to stabilise and begin to ease the UK’s debt burden.

Moody’s could also downgrade the UK’s government debt rating further in the event of an additional material deterioration in the country’s economic prospects or reduced political commitment to fiscal consolidation.

Performance of UK gilts

Three-year gilt performance: long, short & double short (rebased).

Investors who anticipate that the prices of UK government bonds – known as gilts – will fall (yields move inversely to price) in the wake of the downgrade could deploy a short ETF to profit from such a move.

There are currently two products available that provide inverse exposure to gilts, both of which are issued by Deutsche Bank’s Deutsche Asset & Wealth Management unit.

They are: the db X-trackers UK Gilts Short Daily UCITS ETF (XUGS) and the db X-trackers UK GILTS Double Short Daily UCITS ETF (XUSS).

The db X-trackers UK Gilts Short Daily UCITS ETF tracks the Deutsche Bank UK Gilts Short Daily Index, an index measuring the performance of a notional short position in UK gilts plus a money market component reflecting the proceeds from the short. Essentially, the ETF provides the inverse (i.e. mirror opposite) return of a conventional long position in gilts, thereby profiting from declining gilt prices.

The db X-trackers UK Gilts Double Short Daily UCITS ETF is structured in a similar manner to the straight short fund but adds a degree of leverage to the equation – it reflects the performance of a two-times leveraged (x2) notional short position in UK gilts. This double inverse movement means that, for example, a 2% fall in gilt prices would lead to a 4% rise in the ETF on a daily basis, not taking into account the money market component.

The ETFs are listed on the London Stock Exchange and are registered for public distribution across a number of European countries, including the UK. The single short ETF comes with a total expense ratio (TER) of 0.25% while the double short ETF comes with a TER of 0.30%.

While short ETFs such as these can be used for purely speculative trading purposes, they can also be used for less ‘callous’ objectives, such as hedging. For example, an investor with an existing long position in gilts may wish to temporarily hedge out some of this exposure in the aftermath of the downgrade, until the dust settles. This can be achieved effectively by purchasing a short gilt ETF; the double-leveraged version of which may prove more cost-efficient owing to the reduced capital outlay.

Of course, with all leveraged products, investors need to be aware of the effect of gearing, which can amplify losses as well as gains, and understand the idiosyncrasies of leveraged compounding.

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