RPT-Shake-up looms for euro junk debt; some to join EM

Fri Jul 29, 2011 11:03am EDT

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(Repeats with today's date)

By Sujata Rao

LONDON Jul 29 (Reuters) - Billions of euros of junk-rated euro zone debt will soon pour into some emerging market indexes, threatening disarray in European bond markets and serving up disruption for investors who will face hard choices over how to rebalance portfolios.

Bank of America/Merrill Lynch said earlier this month that Portuguese and Greek bonds would exit all investment grade and sovereign indexes at the end of July and move into emerging debt indexes, making it the first major index provider to class junk-rated peripheral euro zone debt as emerging.

The moves are part of an industry-wide shakedown caused by credit downgrades that have relegated Portugal, Greece and Ireland into junk territory.

Because BoA/ML and rival Markit require the country of a bond issuer to be rated investment grade, many bonds from Portugal and Greece, both sovereign and corporate, are no longer eligible for existing investment grade and high-yield indexes.

So far BoA/ML is the only index provider planning to shift peripheral euro debt to emerging indices -- JPMorgan and Barclays do not use ratings as the main parameter for indices.

The other leading high-yield index provider, Markit, will eject some Portuguese corporates from high-yield indexes at the end of July but will not for now class them as emerging.

Analysts say the changes by Markit and BoA/ML threaten to disrupt euro zone bond markets as they will lead to waves of rebalancing by investment grade investors.

High-yield and emerging markets are unlikely to be able to absorb these huge volumes overnight -- and even less so if bigger peripheral markets Spain and Italy were to join the ranks of sub-investment grade sovereigns.

For developing markets, the BoA/ML changes do not threaten major disruptions because BoA/ML indices are not widely used by emerging bond fund managers -- JP Morgan indexes are the benchmark for 80 percent of the industry.

But investors are not keen to see peripheral debt in EM indices and hope others will not follow BoA/ML's example.

Steve Cook, senior corporate portfolio manager at Pinebridge Investments, says emerging corporates have seen a marked decline in volatility in recent years as asset quality has improved.

"If you include peripheral names in an emerging markets index, it could potentially impact the yield and the volatility of the index," Cook said. "An investor that chooses not to hold peripheral debt could underperform to the benchmark in the event of a subsequent sharp recovery."

BIG NUMBERS

Markit says it is consulting on many options, including creating a corporate bond index exclusively for non-investment grade euro zone states. At present it has no corporate emerging bond indexes.

Stephan Flagel, Markit's co-head of indexes, acknowledged a "new reality", in which many issuers classed as emerging may have a higher rating than those that were considered developed.

"Another option is to look at classifications based only on ratings. In the past there was no investment grade in emerging markets. EM was high-yield. Now this is a question that needs to be re-thought," Flagel told Reuters.

A decision could be taken by the end of September.

One problem is that peripheral debt will hugely inflate the relatively small emerging market indexes and funds tracking them will be forced to sell EM debt to make room in portfolios.

"One risk for emerging markets is that if you get this shift, you could end up getting swamped," said Marc Balston, head of emerging debt strategy at Deutsche Bank.

The potential numbers are huge. BoA/ML says that as of next month its emerging sovereign index, the IG00, will contain Greek dollar debt worth 801 million euros as well as Portuguese bonds worth 750 million euros. That looks manageable, given the index's market cap is 146 billion euros.

But the big threat will come if Italy and Spain too end up as junk. BoA/ML estimates Italy alone has 25.3 billion euros worth of bonds eligible for IG00 -- almost a sixth of the index.

BoA/ML's IC00 emerging corporate index for junk-rated securities from sub-investment grade countries has a 51.2 billion-euro market cap. But total debt issued by companies from the five peripheral euro zone states amounts to almost 10 times that.

BoA/ML index acknowledges the risks but said it could help clients get around these issues by offering customised indexes.

(Additional reporting by Sebastian Tong; Editing by John Stonestreet)

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