* 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 (Reuters) - 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 [ID:nLO577770].
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 Stonestreet)