S&P Plans Bond Indexes To Measure U.S. Market Spreads

January 01, 1999

In a move that could significantly help money managers assess the risks of their fixed-income investments, Standard & Poor's said it will unveil indexes that measure the credit spreads in various sectors of the U.S. bond market this summer.

S&P hopes the new indexes become the benchmark for the way investors and chief financial officers evaluate credit and result in the world's first publicly traded credit derivatives. Initially, Standard & Poor's will offer two indexes: the S&P U.S. Industrial Investment Grade Credit Index and one for junk bonds, the S&P U.S. Industrial Speculative Grade Credit Index. Each index will consist of 99 securities.

Later this year, the McGraw-Hill Cos. unit plans to offer an index of investment-grade European companies and possibly a noninvestment-grade European index.

"The world is looking for credit indices," said Ethan Berman, chief executive officer of RiskMetrics Group LLC, a New York-based developer of risk-management systems. "Portfolio managers and risk managers want to have a benchmark against which they can evaluate risk. Bond issuers could also use them to assess the risk premium that investors assign to their securities."

Specifically, the two new indexes will measure the spread, or difference, between the so-called option-adjusted yield of a selected basket of bonds and comparable U.S. Treasury securities. To make its comparisons as accurate as possible, S&P utilizes option-adjusted spread methodologies which neutralize the impact of a bond's individual characteristics such as sinking funds, call provisions and other covenants.

The indexes will be updated daily to reflect the changing movements in credit spreads in both the investment grade and high-yield categories. To build each basket of 99 securities, S&P will have analyzed more than 10,000 bonds according to a list of specific criteria.

"What we are left with is not what Standard & Poor's says the creditworthiness of the bond should be but what the market thinks," said James Satloff, managing director and head of product development at S&Pin New York.

Risk managers foresee a strong demand for both credit indexes and derivatives built on them, not the least because of the crisis that cascaded through fixed-income markets last summer after Russia devalued the ruble and defaulted on $40 billion of domestic debt. Investors dumped risky corporate and emerging-market bonds and fled to the perceived safety of U.S. and European bonds.

"Alot of financial institutions faced unexpected risks and realized losses far greater than their risk-management models predicted," said Michael Zerbs, vice president of research at Algorithmics Inc., a maker of risk-management systems in Toronto. "Akey reason was because the models looked at just general market risk, such as changes in U.S. Treasury rates, and not at changes in credit spreads."

"With the S&Pcredit index models, for the first time we will have the tools to allow us to assess how credit spreads for representative baskets of corporate bonds change over time and what risk-return characteristics they have," he added.

Other companies are developing similar instruments. "It won't take long for these types of products to proliferate," said an observer. "The issue is whether the Standard & Poor's product becomes the one that draws the liquidity." Pointing to S&P's longstanding reputation as an unbiased measurer of credit risk, Satloff is optimistic.

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