Merrill Lynch has launched 17 high-yield indices in the U.S. and Europe that cap the weighting of any single issuer at 3%. Malhar Korde, London-based assistant v.p. in the firm's portfolio strategy group, says a number of large high-yield money managers began using the capped indices as benchmarks almost immediately after they went live. Although the standard unconstrained indices will continue to operate, Korde believes the capped indices will quickly become the standard. "Given the shift we've seen already, it's clear the trend will be toward people using constrained indices," he says.
Merrill first considered creating capped European indices a year ago (BW, 9/30/01) when the bonds of Dutch telecom operator KPN threatened to comprise a third of the outstanding debt in Merrill's European index. KPN never fell into junk territory, and a relatively strong first quarter in the corporate market made the issue less pressing, Korde says.
The constrained indices were developed in consultation with portfolio managers after the global economy soured and a number of large high-grade issuers were downgraded to high-yield. As of last Monday, the largest issuer in the unconstrained European index was Alcatel, at 11.4%. In the U.S., it was Qwest Communications, at 3.2%. Without the caps, it becomes very difficult for portfolio managers to overweight a credit, Korde says. This is particularly true in the European index, because it only has 103 issuers, compared to 800 in the U.S.
Lehman Brothers has already created indices with caps of 1% and 2%, which went live in June, according to Mike Guarnieri, Lehman's head of high-yield research.