LONDON Worries about the euro zone's future are crimping the risk appetite of investors who track government bond indices, fuelling demand for customised packages that strip out higher-yielding peripheral debt.
While the money tracking newly-constructed core euro debt indices still appears small, in part due to concerns about missing juicy yields in the event of a political breakthrough, there is intense interest in customising baskets of euro sovereigns to match individual investor views.
Yields have soared in peripheral bond markets such as Italy, Greece and Spain on concern about debt repayment in the 17-member single currency bloc.
As the crisis has deepened over the past 18 months, Legal & General and Boston-based State Street, fund firms with large numbers of 'passive' investors who rigidly track investment indices, have launched investment vehicles that only contain French, German and Dutch government bonds.
Legal & General, which manages 225 billion pounds in indexed -- or passive -- funds, said its core euro zone bond fund, launched in April 2010, has $500 million (316.8 million pounds) under management.
The fund contains bonds of any maturity issued by the Netherlands, France and Germany, all rated triple-A by all three major ratings agencies.
"It was launched at the request of a European pension fund," said Nick Hodges, business development manager for index products at L&G, adding that most investors in the fund were in Europe, some of whom previously invested across the wider euro zone.
L&G also has a fund containing bonds of the core three states of 15-year maturities or longer, which totals $36 million.
State Street Global Advisers, which manages $1.9 trillion in assets globally, launched a core fund in June, split 40:40:20 between Germany, France and the Netherlands.
The bond already has $265 million under management.
"It has proved very popular with some investors," said Niall O'Leary, head of EMEA product engineering at SSgA.
BUILD YOUR OWN
Government bonds have traditionally been seen as 'risk-free' securities, but planned debt writedowns on Greece and fears of similar moves across the euro zone periphery has forced a rethink.
In addition to off-the-shelf products, investors are looking for custom-built indices to track. With so many possibilities about who might or might not default or leave the euro zone, it's hard for one product to match investors' needs.
"One size does not fit all when you get down to this level of emotion," said O'Leary.
Many of global bond indices such as those compiled by Citi, JPMorgan or Merrill Lynch have already ejected Greece, because its "junk," or sub-investment grade, credit ratings are too low for the benchmark.
But investors may have other worries, such as whether France will lose its triple-A rating, or Italy will have trouble repaying its debt.
"If a client asked if we could construct an index that's just limited to AAA government bonds, yes we can; to AA, yes we can," said O'Leary.
One trend in play is to customise JPMorgan's EMU sovereign bond index to strip out the peripheral euro zone bond markets.
Another series of benchmarks attracting attention are Barclay's recently launched fiscal strength-weighted bond indices.
These deal with the problem prevalent in regular bond indices, in which countries with heavy amounts of debt, like Italy, carry larger weightings than sounder economies, like Germany.
But investing only in core markets also keeps yields down, carrying its own risks for investors seeking larger returns.
"It's also possible you are making the wrong decision, selling Italy just because yields are at 7 percent -- it could be the deal of the century," said O'Leary.
One way around this for many investors has been to look at other high-yielding markets, such as emerging markets or corporate credit, to complement their core euro zone trade.
Jeff Molitor, Chief Investment Officer, Europe for Vanguard -- which manages close to $1.9 trillion in assets globally -- reckons slicing up existing indices too much is rarely likely to be effective.
"What we see is that trying to second-guess the index has never tended to be the right solution for investors, though it can make people feel better for a while," he said.
"No one really knows if there is going to be a (euro zone) break-up -- on that basis, how do you decide who is in and who is out?"
(Editing by John Stonestreet)