August 27, 2009 / 10:52 AM / 10 years ago

New high-yield bond indexes exclude bank debt

* Junk bond markets swamped by lower-ranking bank debt

* Bank debt inflow alters index risk profile, investors say

* Some see opportunities in bank debt as strategies vary

By Jane Baird and Natalie Harrison

LONDON, Aug 26 (Reuters) - Bank of America-Merrill Lynch has launched new high-yield bond indexes to exclude bank debt, which has flooded the junk market this year and upset investors whose strategies focus mostly on industrial companies.

The move by the leading provider of high-yield indexes came at the instigation of fund managers, who see bank debt as subject to political pressures more than to factors they typically analyze, such as debt ratios and cash flows.

“The index suddenly had the contamination of all these financials coming in and distorting the strategy,” said Alex Vaskevitch, a manager at hedge fund LNG Capital.

“We deal with corporate debt, not banks, because that involves political issues and other issues not in line with our strategy, so we wanted to clean it out of the index.”

Senior bonds from crisis-hit banks often continue to be ranked investment grade, but subordinated debt has frequently fallen to junk, particularly Tier 1 perpetual notes — or hybrids — which rank between debt and equity.

Banks can stop making payments on the debt without triggering default, and European countries have told a number of banks they rescued with taxpayer money to do so, introducing hard-to-predict policy risk into the market.

Before the wave of bank debt, the European junk bond market consisted mostly of industrial and service companies such as Norske Skog, HeidelbergCement or TUI AG, whose bonds require an analysis of fundamental and financial factors.

“For us, the European corporate credits are a more accurate picture of what high-yield is,” said Peter Aspbury, head of high-yield research for European Credit Management.

Royal Bank of Scotland (RBS.L), Commerzbank and Bank of Ireland BKIR.I are all examples of bailed-out banks, whose senior debt is still rated investment grade but whose lower-ranking paper is now junk.

DO YOUR HOMEWORK

Financial debt had swollen to around 14.4 percent of Banc of America-Merrill’s global high-yield bond index as of Aug. 21 from around 2 percent in early 2007. In Europe, the sector accounts for more than 24 percent of the euro bond index and almost 59 percent of the sterling index.

“We have released many indices over the past half-year to year that exclude various segments of the financial sector,” said Phil Galdi, managing director of global bond indices at Banc of America Securities-Merrill Lynch.

Junk bond managers who ignored junk-rated bank debt over the past six months are likely to have underperformed the main index as Tier 1 prices have rebounded to between 30 and 50 cents on the euro from lows below 10 cents in March.

“I can imagine there will be plenty of high-yield fund managers crying into their bonus pots,” said Philip Milburn, a fund manager at Aegon Asset Management.

“Our mandate from clients is to get as good a return as possible from anything that is rated high-yield,” he said.

British fund firm Liontrust Asset Management (LIO.L) began looking at subordinated bank notes in February and March.

“We had to do an enormous amount of work on it,” said Paul Owens, head of fixed income research.

Owens pored over 250-page regulatory filings to evaluate bank finances as well as 300-page prospectuses from five and six years ago to sort out complex legal language determining whether a security was more or less likely to be repaid.

He reviewed historical precedents including Continental Illinois, the U.S. savings-and-loan crisis and Sweden’s banking crisis for clues on what regulators were likely to do. “You had to figure they were reading the same documents we were.”

The resulting Tier 1 investments “have been very good to us”, Owens said. “If you do that homework, you can get handsomely paid for it.” He added, however, that the firm will probably not have Tier 1 in its portfolios a year from now.

ECM, meanwhile, manages subordinated bank debt separately from its non-financial high-yield exposure.

“We consider it to be its own asset class, and where we do buy it, it is for diversified funds where we have a remit to invest in virtually any asset class considered to be European credit,” Aspbury said. (Editing by Rupert Winchester)

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