The danger of indexes

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HEARD ON THE STREET
NOVEMBER 11, 2009, 1:30 P.M. ET
Contingent Capital's Tricky Path

By RICHARD BARLEY
Contingent convertibles may become a key part of the future bank-capital landscape, but their path to widespread acceptance is unlikely to be smooth. The nascent instruments this week suffered a setback in an arcane yet critical row over their inclusion in bond indexes used by investors around the globe. The outcome could be reduced investor appetite for the bonds.
Lloyds Banking Group is currently offering to exchange as much as £7 billion ($12 billion) of contingent convertibles for existing subordinated debt as part of a bigger £21 billion capital raising to free itself from the U.K. government's toxic-asset insurance plan. The notes have a fixed maturity but will convert into equity if Lloyds's core Tier 1 capital ratio falls to less than 5%.
Many bond investors, the traditional buyers of bank hybrid capital, don't want these bonds included in bond indexes because they are prohibited from owning equity. Bank of America Merrill Lynch, which compiles some of the most widely watched bond indexes, initially agreed, then changed its mind only to change it back again after the Association of British Insurers complained that investors might be forced to buy the notes because of their inclusion, but then be forced to sell upon conversion at a time of market stress. That is a brave but welcome decision. Barclays Capital also isn't including the notes in its corporate-bond indexes; iBoxx is making its mind up about them.
Lloyds's deal may work, as it is making investors an offer that is difficult to refuse--unexchanged bonds are set to have payments blocked by the European Commission as a condition of state aid. But the bond debate is a blow for any hope that contingent convertibles are the solution to banks' capital woes. It also underlines the limitations of the structure: While undoubtedly an improvement on traditional hybrid bonds, their success depends on a similar ambiguity over where they sit in the capital structure between debt and equity. That makes them an unlikely silver bullet.
Write to Richard Barley at richard.barley@dowjones.com
Copyright 2009 Dow Jones & Company, Inc. All Rights Reserved


My Comment
What a sad commentary this is on the investment management industry, and a classic example of the tail wagging the dog. In deciding whether something is a good investment for the medium to long-term, there should be no consideration of whether it is in an index or not. That index inclusion is a major stumbling block shows how many of the fund managers, despite their high fees, have abrogated the most basic role of an investment manager.