If the off again, on again crises in European sovereign bonds seem to defeat the idea of safety in diversification, then a new crop of bond exchange-traded funds and bond funds that behave like eurodebt but have little or none of it in their portfolios could provide your clients with exposure to these debt markets without their inherent problems.

Despite the bailout package promised by European Union finance ministers on May 10, the underlying fiscal imbalances and lack of a central tax discipline for member states remain. Chances are that Greece’s bond disaster or some other European debt crisis will reappear.

“Sovereign bonds used to be seen as places to hide in a crisis,” says Marc Stern, vice president and portfolio manager with Industrial Alliance Securities Inc. in Mon-treal. “Now, they have become the crisis. The world is witnessing a progression of debt contagion from one country to the next.”

For advisors who want to maintain clients’ exposure to global interest rates without Europe’s debt problems, a host of new synthetic bonds and bond ETFs have come to market. All allow bond portfolios to have global bond exposure without Europe’s problems.

The first question for any client who wants to diversify out of Canadian government bonds is: why bother? The answer, of course, is that there are definite risks in being isolated in Canadian debt. Driven by the recovering global economy, Canadian interest rates are due to rise. The course of wisdom is to spread macroeconomic risks into global sovereigns — and, these days, to avoid the risks of default by several European issuers.

The top three bond issuers by volume have been: the U.S., the only source of the world’s only respectable reserve currency; Europe, which until recently had an up-and-coming reserve currency; and Japan, which is saddled with very low interest rates and national debt that is 200% of its gross domestic product.

Global diversification, once part of the idea of modern portfolio theory, is in jeopardy. The challenge now is finding the bond issuers that are safe — and that is a diminishing list.

Data from the Bank for Inter-national Settlements shows that banks in France and Germany, combined, hold 51% of all outstanding Greece bonds. Add on the rest of the euro area and 72% of all Greece’s bonds are accounted for. Problems in Athens suggest that major European banks will report losses on these asset sales. The implication: the European bond crisis is not over.

“The markets are expecting that the European banks will take a haircut,” says Patricia Croft, chief economist with Royal Bank of Canada’s global asset-management division in Toronto. “The banks affected will have to cut their lending or issue more debt at high costs.”

But a solution to the spreading risks of global bond investing has arrived, courtesy of recent product innovations. Among the most inventive are London-based Markit Group Ltd.’ s iTraxx SovX funds, which have come to market since November 2009, when Dubai’s threat to restructure some of its national debt began the sovereign default angst.

@page_break@The latest invention is the iTraxx SovX Asia Pacific ETF, composed of bonds with five-year average maturities, equally weighted with issues from Australia, China, Hong Kong, Indonesia, Japan, South Korea, Malaysia, New Zealand, the Philippines, Thailand and Vietnam. SovX Asia Pacific, which began to trade on May 4, contains debt issues that have been relatively immune from the crises that have shaken world capital markets.

As European sovereign bond yields have risen, iTraxx SovX Asia Pacific yields have held steady, resulting in a closing of yield spreads to a recent level of just 1.1% over European benchmarks. The iTraxx ETF appears to reward bond investors for investing in a euro-clone immunized from Europe’s problems.

The iTraxx SovX tradeable ETFs variously isolate or exclude European risks. For those who want to bet that European bonds, recently selling at huge discounts, will extend the recovery that began on May 10, there is the iTraxx SovX Western Europe portfolio of 15 sovereigns. For doubters, there is iTraxx SovX CEEMEA, which tracks 15 emerging markets and Middle Eastern sovereigns; the iTraxx SovX G-7, which tracks the top industrialized countries in the world; and the latest Asia-Pacific iTraxx construction.

As well, several seasoned global bond ETFs provide narrower country selection, term and duration choices. For example, Wheaton, Ill.-based Invesco PowerShares Capital Management LLC’s PowerShares Emerging Markets Sovereign Debt ETF has flourished amid the European debt crisis.

It is arguable that the crisis in European bonds is a buying opportunity. All crises end, and this one will eventually be laid to rest. Rather than run from the crisis, you might choose to embrace it and buy European bonds for your clients at a large discount for a margin of safety and as a platform for gains.

The problem for retail investors is finding the issues, and then getting reasonable pricing. However, closed-end global bond funds specializing in currently volatile global bonds offer both easy trading and long-term income potential. One of the biggest closed-end bond funds is Toronto-based Franklin Templeton Corp.s Templeton Global Income Fund. It has no bonds issued by Greece; it is payable in U.S. dollars; and it sells at a 2% premium to net asset value.

For most trades in global debt, currency problems go with underlying credit and macroeconomic trends. But it’s possi-ble to get foreign-currency European bonds in Canada’s Maples market or to buy US$-denominated bonds from most member states. These eliminate the currency risk, notes Benoît Poliquin, vice president and bond specialist with Pallas Athena Investment Counsel Inc. in Ottawa.

Finally, you could accept the European bond mess and use it as a way of buying bonds that are perhaps sounder than other sovereign issues, at deeply discounted prices. Suggests Poliquin: “Buy strong corporate issues in Europe. They are priced off sovereigns, so you get the discount on a stronger bond.”

The final question: whether to invest in these markets or to flee.

The potential rewards for shrewd timing exist, but Greece’s bonds, which yielded almost 19% at the end of April, were hostage to May mobs. A massive fix promised by the EU may reduce tensions, but for clients who want to avoid credit risk, the alternatives to European debt have to be considered. IE