* Core Tier 1 debt seen too risky for investment-grade funds
* Some managers turn to indexes excluding Tier 1
* Other investors are avoiding using indexes at all
* Yields on new issues to compensate for altered sentiment
By Jane Baird
LONDON, Aug 24 New investment-grade bond indexes
that exclude low-ranking bank debt have entered the market -- a
recent sign of soured investor sentiment that will force banks
to pay high yields to raise Tier 1 core capital.
The financial crisis has reduced subordinated ratings of
banks that have been bailed out by governments to junk status.
"But 4.5 to 5 percent of the global investment-grade indices
is still subordinated debt", said Dominic Pegler, co-head of
global fixed income strategy at asset manager BGI.
"We have had investors come to us and say they are concerned
about this, so we have built portfolios with a global index
where we take subordinated bank debt out," Pegler said.
Tier 1 notes, also called hybrids, are a cross between debt
and equity. They are typically perpetual securities with call
dates, which a bank can ignore. A bank also can stop paying
interest on them without triggering a default.
In the boom years, hybrids acted like debt, paying slightly
higher fixed returns than senior bonds. But in the downturn they
are now acting like equity as crisis-hit banks, pushed by
governments, stop paying interest and principal on them.
At end-June, Markit introduced a series of iBoxx
investment-grade sub-indexes -- some excluding Tier 1 and some
stripping out all subordinated financial debt -- and it plans to
put them on its Web site for widespread use in September
BGI, which runs $83 billion in active fixed-income asssets
globally, at end-July launched the Global Credit Screened Fund
based on a custom-made investment-grade index stripped of Tier 1
and Upper Tier 2 bank debt.
"It is difficult to accept that a security ... that allows
for failure to make coupon payments and not be in default should
be included in an investment-grade universe," said Lisa Coleman,
head of global credit fixed income at JP Morgan Asset
Management, who mostly steers clear of them.
NEW TIER 1 COMING
Pension consultant Mercer has been helping managers over the
past six months launch "benchmark agnostic" bond portfolios,
said Paul Cavalier, global head of fixed income research.
They aim to take advantage of the current stage of the
credit cycle by buying bonds at high spreads from good companies
to produce a certain percentage return over five years or less.
"We don't want to ask managers to be pitted against a
benchmark index that includes some assets that are cheap but
take too much risk, such as Tier 1 bank debt," Cavalier said.
While investors reassess hybrid debt and find ways around
the main indexes, banks that steered clear of government support
are preparing to offer new Tier 1 notes beginning in the autumn
as they seek to build capital. [ID:nLU678795]
On Monday, Deutsche Bank (DBKGn.DE) said it plans to issue
new Tier 1 debt, which could reopen the market in Europe.
Stephen Lane, Calyon's head of global credit trading for
Europe and Asia, said deal managers will sound out investors to
determine yields that would be attractive for them.
"The investor base for and the confidence in these products
has certainly been diminished, but this will be reflected in the
prices of the forthcoming issues," Lane said.
Secondary markets already reflect a large mark-up for
subordinated debt. Tier 1 debt from BNP Paribas (BNPP.PA) yields
around 9 percent, compared with five-year credit default swaps
on its senior debt at 60 basis points.
And Barclays Bank (BARC.L) Tier 1 yields around 17 percent
vs 95 basis points for its senior CDS.
But investor interest has been sparked after prices
rebounded from depths in March, providing a return of more than
9 percent in July alone.
Meanwhile, fund managers are struggling to get their hands
on enough bonds with investment-grade ratings to satisfy a
strong inflow of investor money.
Calyon's Lane said he expected the first new Tier 1 issues
to offer the most value for investors, but then yields to fall
in subsequent deals as investors regain confidence.
"I don't have a problem with people taking off-index
positions as long as they are doing it because they think they
are buying something that is really valuable," said Margaret
Frost, global head of fixed income manager research at Watson
Wyatt Worldwide WW.N.
Meanwhile, she expects to see a widening discussion on the
role of Tier 1 in investment-grade indexes.
"When all the dust settles and people think what constitutes
an appropriate bond benchmark, they should ask very tough
questions about whether or not a security that has potential to
never mature should be in there. My answer is 'no'," she said.
"Banks have to make this stuff so attractive that even if
it's not in an index an active manager would still buy it."
(Additional reporting by Claire Milhench; editing by John