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The Battle of the Euro Bond Indices

By Andrew Webb

Which bond index will rule in post-EMU Euroland? In recent weeks, Merrill, Salomon and Lehman have all launched new investment-grade bond indices. The winning index will become an integral part of fixed-income derivative trades in the new Europe. In the past, the first index to market has tended to be the one that sticks, but with three similar products emerging in a matter of days (closely followed by two further offerings from Barclays and Bear Stearns), all bets are off.

So are the gloves, since the contenders have not been slow to denigrate each other’s offering. Aram Flores of Lehman’s London Portfolio and Index Strategy Group has been keen to extrapolate Lehman’s claimed market share (75 percent) of indexed U.S. bond business to Europe, and on this basis predicts that Merrill (with 5 percent) will fall by the wayside. Flores also notes that Salomon requires issues to be at least $500 million euros to be eligible for inclusion in its index, and that, he says, will exclude some of the most active European corporate names.

Salomon’s riposte (which includes a sideswipe at Merrill) is that the other two indices must contain a great deal of illiquid paper since both include around 7,000 issues as opposed to under 800 in its own. Merrill, by contrast, has confined itself to promoting the virtues of its own index—such as its distribution mechanism via Bloomberg, which will allow traders to not only see which bonds were constituents of the index on a particular day, but also the prices allotted to them in index calculation.

At stake in this index war is a major slice of a fixed-income pie likely to match that of the U.S. market in size. “The kudos of having your name on a benchmark index of that importance will be considerable,” says Bob Attridge, head of fixed income at Old Mutual Asset Managers in London. “However, the real benefit lies in the flow of corporate borrowers that it will attract as well as opportunities in the secondary market.”

The benefits on the buy side are not to be sneezed at either. “The quid pro quo is that investors will come to you for their index data and in the process give you at least part of their trading business,” says Gabriel Irwin, senior portfolio manager at Prudential in London.

Although the income from these sources will be considerable, the real focus of the new indices is to capture a juicy piece of the burgeoning European credit derivatives market. “The derivatives market that will evolve in transactions linked to these indices is potentially enormous,” says Phil Galdi, head of Merrill’s quantitative analysis and portfolio strategy department in New York.

The real joy for the investment banks is twofold. First, European investment managers post-EMU will no longer be able to add value through country and currency selection and will have to turn to playing credit spreads. Second, a majority of those managers (unlike their U.S. counterparts) are relatively inexperienced in this type of trade and should provide fertile ground for education and sales of products such as total return swaps.

However, in the early post-EMU stages, other derivatives products based on these indices are likely to lead the way. “I think it will be the structured note business that will probably take off first in Europe, because that doesn’t require a change of mandate and approval to enter into swap contracts, whereas in the U.S. most of the business has been in swaps,” says Galdi. “As derivatives products based on these indices evolve and become liquid, however, they will provide a whole host of new tools for the portfolio manager. Specifically, it will allow them to cope with existing problems such as hedging sectors of a portfolio that contain significant credit risk.”

Although these investment-grade indices are in themselves significant in derivatives terms, the bank that wins will also be in a strong position regarding a follow-up product for high-yield bonds. Given the enormous growth in credit derivatives activity in the high-yield U.S. market over the past year, the opportunities in the relatively untapped European market look exceptional.

It appears that Wall Street will be capturing the lion’s share of this business—in the early stages at least. “I think it rather says it all that no European bank has come up with a benchmark,” says Robert McHenry, fund manager at Connecticut fund manager HIMCO. “From our point of view, the U.S. has been far more imaginative. With convergence trades becoming history, the market could come to resemble that in the U.S. You’re already seeing the increasing demand in Europe for those with asset-backed and mortgage-backed expertise reflecting that.”

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