Merrill Lynch is considering whether to change the rules for its Euro High-Yield Index, capping the weighting of any single issuer at between 5-10%. Behzad Mansouri, v.p. portfolio strategy group, says the question is being investigated because of the potential downgrade to junk status of Dutch telecom operator KPN. Mansouri notes that this is important because a KPN rally would cause high-yield investors benchmarked off the index to significantly underperform the index. He says that with outstanding paper worth roughly $5.96 billion last week, KPN paper would account for 33% of the index. Such a percentage would dwarf the current leader, Marconi, which was still being added to the index but was expected to comprise close to 5%. "There has been a good deal of investor concern about this question," he says."Many of them are limited as to how much they can invest in a single issue."
Downgrades last month by Moody's Investors Service and Standard & Poor's have sent KPN to the lowest rung of investment-grade on both scales. Moody's has KPN on review for possible downgrade, and S&P has it on negative creditwatch.
Mansouri says Merrill may choose to simply market weight issuers such as KPN, or to run parallel indices. The firm is not leaning toward any one solution at the moment. Merrill will probably make a decision within six months, but could decide within the next one to two months. It will not, however, wait to see whether KPN will actually be downgraded to junk. He says the firm will probably have to give at least one month's notice before changing the rules of the index.
Walter McGuire, global high-yield strategist at Deutsche Banc Alex. Brown, says his firm has no plans to install a market cap in its indices. He says that First Boston came under severe criticism in 1989 when it capped its high-yield index following a massive issue by RJR Nabisco. More recently, he says Nasdaq came under fire when it capped the weighting of a single stock in the NASDAQ 100 at 24% in response to a rapid rise in the value of Microsoft. In both cases, the cap became insignificant as the weightings fell back to earth.
But Deutsche Banc's rationale for not instituting a cap is philosophical, says McGuire. "An index is supposed to be a robot. You set it up and it keeps going. That's why it's a reliable benchmark. The impact is the same on portfolios whether the index rules are changed or not." Sam DeRosa-Farag, director of global leveraged finance strategy at Credit Suisse First Boston, who McGuire says was behind the change to the First Boston index, did not return calls.
European high-yield investors appear to be divided about what Merrill should do.Sara Halbard, portfolio manager at Intermediate Capital Group, says Merrill will have to cap the index.Martin Reeves, high-yield portfolio manager at Alliance Capital in London, believes the question is open for debate. "Is an index meant to be representative of how well managers can manage or of all the bonds out there? In many ways, I suppose it doesn't matter. Each manager can come to an agreement with investors. You don't necessarily want index providers making these kinds of decisions."