Indexology^® Blog

Municipal bonds yields have come down at a faster pace than U.S. Treasury bond yields helping to push up bond prices. Equity and currency market volatility is helping to drive cash inflows for municipal bond funds and when combined with manageable new issue supply has helped foster a stronger muni bond market. The S&P National AMT-Free Municipal Bond Index tracking investment grade bonds has started 2014 with a positive total return of 2.34%. The average yield of bonds in the index has fallen by 36bps since year end out pacing the drop in yield of the 10 year US Treasury bond.

Puerto Rico municipal bonds stung the bond market in 2013 with the S&P Municipal Bond Puerto Rico Index falling over 20% during the year.  That index has seen a rally of 3.7% in January as the average yield of Puerto Rico bonds in that index has improved to 7.19% from 7.44% at year end. Possible new bond issuance from Puerto Rico will test the depth of market’s appetite for these bonds in coming weeks.

Tobacco settlement bonds have benefited from yields coming down. The S&P Municipal Bond Tobacco Index has seen a positive total return of 4.72% year to date as average yields of bonds in the index have dropped by 33bps in January.

Five year municipal bonds tracked in the S&P AMT-Free Municipal Series 2019 Index have seen yields come down by 33bps to end at 1.63%. The S&P AMT-Free Municipal Series 2023 Index have seen yields come down by 36bps to end at 2.88%. Out longer, 20 year bonds tracked in the S&P Municipal Bond 20 Year High Grade Rate Index have seen yields come down by 45bps to end at 4.1%.

Investors and some central bankers believe in forward guidance – that announcing what the bank will do well before it does anything can control the economy.  One proponent is Mark Carney the governor of the Bank of England (BOE) and previously head of the Bank of Canada. In a speech earlier today at Davos he told people to ignore statements made last summer about how the BOE would respond to a falling unemployment rate and offered a new twist to forward guidance: the BOE’s Monetary Policy Committee would re-think how to do forward guidance if they needed to change their mind.

Forward guidance, the idea that central banks can use announcements of future policy moves as a way to affect the economy gained popularity in recent years. In simple terms, if the Fed, or the Bank of England, says it won’t raise interest rates until unemployment drops, people respond by confidently borrowing and spending.  Central bankers were once tight lipped fearing that any comment might spook bond traders and damage the economy. After the financial crisis with interest rates pegged at their zero lower bound, a new tool for economic management was needed.  The answer was to tell the markets what the bank would do and then watch the economy follow instructions.

Forward guidance apparently works – markets and investors take note and respond as desired.  Central bankers can move the economy in the direction they want just by issuing official statements. But it only works as long as people believe what they hear. This is issue before Mark Carney and the Bank of England – and the issue about to confront the Fed and its soon-to-be chairperson Janet Yellin.  Unemployment rates in both the US and the UK dropped more than expected in recent months. Both banks’ forward guidance is on the record with unemployment targets for when interest rates might increase.  The Bank of England is sufficiently close to their target that they hint they may change their mind. We will need to read their upcoming February Inflation Report in hope of finding forward guidance 2.0.

Over at the Fed the details differ. The last employment report was unexpectedly weak so now everyone is wondering if another weak report will change their plans for tapering QE, their last public statements indicated.  A few days ago a page one article appeared in the upper right hand corner of the Wall Street Journal quoting two of the regional Federal Reserve bank presidents commenting that the Fed would continue to taper QE regardless on the employment report due on February 7^th.   While this isn’t official forward guidance from the Fed, it is journalism – and some parts old time jaw boning, whispering and hinting.

A decade or two ago, before Central Bankers believed in maximum transparency, when the Wall Street Journal was a monotone grey paper only read within a few blocks of its namesake location, the way the Fed communicated with the markets was an occasional story in the upper right hand corner of page one quoting an unnamed senior Fed official. Unstated was the belief that the senior Fed official might be the chairman himself.  What was said sounded a bit vague and much less definite than today’s official statements. The element of uncertainty in the article forced investors to think through their own market forecasts and strategies knowing that the Fed might change its plan when the data changed.

Maybe some other senior officials at the Fed or the Bank of England today might prefer the old fashioned kind of forward guidance.

When I see a forecast of freezing weather, unlike most, I don’t think about how I will dress warmly or prepare for the cold.  As a commodity lady, I think about how much the price of natural gas will increase. However when I saw this on TV yesterday, I had more food for thought than just the price of natural gas.  Notice Friday’s high is listed as 18 degrees Fahrenheit (about -8 Celsius) while the low is listed as 19 degrees Fahrenheit (about -7 Celsius).

I only chuckled for a moment before thinking about natural gas again.  Natural gas has been the best performing commodity in the S&P GSCI so far in 2014, up 8.6%. It is also in backwardation with the spot only up 7.6%, which is relatively rare. You can see in this chart below that natural gas has been in backwardation in only 13% of months since 1994.  Also, it has only been in backwardation in 10 months within the past 10 years with an average premium of 39 basis points. That is about 60 basis points less than the premium thus far in January 2014.  What is less unusual about the backwardation is its January appearance since backwardation has always happened in extreme cold or heat.

Since 1995, there have been 8 positive January months with an average return of 9.1%.  The highest return in January was in 2007, when the S&P GSCI Natural Gas returned 21.7%.  Although there was a slightly positive return in 2008 of 34 basis points, 2014 has the first significant positive return since 2008, 6 years ago, when the monthly return was 7.9%.  Please see the chart below:

The question is what has happened following a positive January for natural gas?  In years with positive January months, average first quarter returns were 14.7% for the spot index and 18.7% for the total return. Average annual returns were 49.9% for spot natural gas and 38.5% for the total return, but without the crisis years, the average annual return was double.

Please see the table below:

Check out this infographic in our quarterly magazine, INSIGHTS

The fixed income market is quintessential for the growth of the economy. They serve as one of the mediums for the government to raise money. In India the fixed income market has been attaining the depth as well as maturity over the years and the government securities play a dominating role.

The on-the-run 10 year fixed interest rate bond issued by the Reserve Bank of India is treated as the benchmark and serves as a reference point for pricing of the other bonds along a yield curve. The S&P BSE India 10 Year Sovereign Bond Index seeks to measure the performance of the benchmark security and can be considered as the bellwether index.

Fixed income market returns in general tend to be less volatile as compared to the equity market returns. This is very well depicted in the performance chart below. We can observe that S&P BSE India 10 Year Sovereign Bond index is less volatile as compared to S&P BSE SENSEX index.

Average inflation in India was low during 2003 to 2007 and S&P BSE SENSEX index did well in these years. The S&P BSE India 10 Year Sovereign Bond Index remained mostly stable. In the year 2008, which was marked by recession, the S&P BSE SENSEX index nosedived, whilst the S&P BSE India 10 Year Sovereign Bond Index rose. Since 2009, the S&P BSE SENSEX index has improved significantly and the S&P BSE India 10 Year Sovereign Bond Index has also shown stable growth. The risk percentage and the annualized returns of the S&P BSE India 10 Year Sovereign Bond Index are low vis-à-vis S&P BSE SENSEX Index. The correlation of monthly returns in both the asset classes is very less and it decreases further as the time span increases. Table below summarizes the statistics.