Indexology^® Blog

On my daily commute to New York City via New Jersey Transit today I overheard a conversation on the train that started with “Back when I was a kid”.  Though the start of the conversation had grabbed my attention, the rest became a blur as the statement had triggered memories that related to the current article I was reading on my IPad.  The combination of a fellow commuter’s overheard statement and E.S. Browning’s article Inflation Is Back on Wall Street Agenda got me thinking about being a kid in the 1970’s.

Back then news was not a major focus of mine as I had more important things like Little League Baseball and CYO basketball to occupy my time.  Though there are memories of newscasts on our black and white television or overheard radio reports from the back seat of my dad’s Ford Fairlane.  Even as a kid I knew the economy was a mess.  Oil prices never went down, gold was a hot commodity and Inflation sounded more like a monster than an economic concept.  Now I’m not saying we are due for a 1970’s economy, just that the idea of inflation has had a long lasting impact on me and others of the time.

In addition to my memories of the past, Mr. Browning’s article made for an interesting read to fill the time of my commute.  Lightly touched upon in the article was the financial product of TIPS (Treasury Inflation Protection Securities).  These securities did not exist “back then” but were issued by the U.S. Treasury in 1997, specifically to protect against the eroding effects of inflation upon the principal of fixed income securities.  The S&P U.S. TIPS Index has returned 4.88% year-to-date, though longer indices such as the S&P 10+ Year US Treasury TIPS Index are returning 10.10% year-to-date.

Another addition to the U.S. Treasury’s portfolio of products, which would be beneficial to investors in a rising rate environment, is the recently issued floating rate product.  On July 31, 2013, the U.S. Treasury published amendments to its marketable securities auction rules to accommodate the auction and issuance of a Floating Rate Note (FRN).  Treasury FRNs are indexed to the most recent 13-week Treasury bill auction.  $15 billion of 2-year FRN was first issued on January 23^rd, 2014.  The S&P U.S. Floating Rate Treasury Index is returning 0.04% month-to-date and is made up of the originally issued January 2016 maturity along with a more recent April 2016 issue.

Source: S&P Dow Jones Indices, Data as of 6/20/2014

Last week’s Consumer Price Index (CPI) release spooked a few people with a month to month change of 0.4%, the largest since February 2013; food prices were up 0.7% and the CPI ex-food & energy up 0.3% with both rising the most since August, 2011.  To top it all, the twelve month change in the CPI was 2.1%, above the Fed’s 2% target. The immediate responses were (1) the Fed is going to raise interest rates a lot sooner than anyone expects and (2) the Fed will still wait for at least a year before raising rates and by that time the central bank will be “behind the curve” and inflation will have returned with a vengeance. Anxious bond holders believe the first story while unreconstructed monetarists (who are still waiting for inflation after five years of quantitative easing) put their faith in the second story.

The Fed chair, Janet Yellen, doesn’t believe either story. Rather, she is far less concerned about inflation and less worried about last week’s CPI report than most.  First, the CPI may, or may not, be a reliable gauge of inflation, but it is not the gauge the Fed follows.  The Fed bases its policy guidelines on the personal consumption expenditures (PCE) implicit price deflator.  The twelve month increase in that measure in April was 1.6%. (The May number isn’t available yet.) While that is higher than recent figures, it is comfortably below the Fed’s 2% target and it is in the range of the Fed’s economic projections published last week. Using the right numbers, inflation is exactly where the Fed’s policy guidelines expect it to be.    The Fed’s projections for the PCE Deflator are 1.5% to 1.6% for 2014; 1.6% to 2.0% for 2015 and 1.7% to 2.0% for 2016.

Other inflation measures do not point to a jump, or even a modest rising trend, in inflation. The Cleveland Federal Reserve Bank publishes a range of inflation indicators.  The Median CPI is one of the more reliable figures and it was 0.3% per month in April and May compared to 0.2% in January through March.  Both major consumer and professional forecaster surveys do not expect any increase in inflation.

What does all this mean for Fed policy? Very little.  However, we are likely to hear a lot more nervous talk about inflation during the summer. Gasoline prices may rise – they usually do in the summer driving season whether or not there is a war in the Middle East. Food prices may also climb since drought and fire conditions in California haven’t improved much.  Other prices – and hopefully wages — could also creep up as the economy continues to improve.  Janet Yellen is correct that inflation is volatile; anxiety about inflation is even more volatile.  These days that may be the only real volatility in the financial markets.

Lipper reports high yield bond funds have seen the first cash outflow in 7 weeks which might be a sign that junk bonds could run out of gas.

Over the last five years the S&P U.S. Issued High Yield Corporate Bond Index has seen annualized returns of over 13.6%. Year to date the index has returned 5.43% as yields have ended at 4.84% impacted by a 55bp drop since year end. By comparison, safer 10 year US Treasury bonds have seen yields drop by 40bps and have returned 5.17% year to date.

Can more juice get squeezed out of the junk bond sector? Looking at incremental yields of different asset classes can be revealing:

• The yield of the S&P U.S. Issued High Yield Corporate Bond Index is 4.84% or 203bps higher yield than investment grade corporate bonds.
• This is the lowest spread differential seen during the last two and half years of quantitative easing. During that time this spread has gotten as high as 317bps in June 2013.
• High yield bonds are now only 221bps higher in yield than yield of the 10 year U.S. Treasury bonds.
• High yield bonds are only 61bps higher in yield than the yield on senior loans tracked in the S&P/LSTA U.S. Leveraged Loan 100 Index.
• High yield bonds are 135bps lower in yield than the yield of high yield municipal bonds tracked in the S&P Municipal Bond High Yield Index.

The S&P Municipal Bond Index has returned 5.74% year to date as yields have remained relatively stable as the market absorbs new issue supply. High yield municipal bonds tracked in the S&P Municipal Bond High Yield Index have continued to outperform their corporate junk bond counterparts by returning 9.67% year to date. As the yields for U.S. corporate junk bonds has hit lows well below 5%, municipal high yield bonds in the S&P Municipal Bond High Yield Index have remained over 6%.

• Longer dated municipal bonds have outpaced U.S. Treasuries with the S&P Municipal Bond 20 Year High Grade Index returning 12.48% year to date. The 3.75% tax-exempt yield of these bonds remains over 25bps cheaper than the 30 year U.S. Treasury Bond.

• Tobacco settlement bonds have rallied all year as the S&P Municipal Bond Tobacco Index has returned over 13.2% as yields have fallen by over 100bps to end at 5.9%.

• Puerto Rico General obligation bonds may have hit a ceiling in their 2014 rebound. The S&P Municipal Bond Puerto Rico General Obligation Index has returned 9.86% year to date after losing ground over the last week as yields have risen on average by 10bps.

A consideration to take into account when reviewing preferreds is the fact that they are sensitive to changes in interest rates.  The reasoning behind this is due to the structure of preferreds, as many issuances pay a relatively high dividend based on a percentage of par in perpetuity.  Like bonds, preferreds generally exhibit a negative relationship to interest rate changes.  When there is an increase in interest rates, the present value of future dividend payments decreases, and thus, the price of a preferred share would be expected to fall.

How can one estimate how sensitive preferreds are to interest rates? One way is to look at the effective duration of the asset class.  Duration is a tool that estimates price sensitivity to changes in interest rates; more specifically, it is the approximate percentage change in price resulting from a 100 basis point change in interest rates.

Using the empirical method by regressing historical portfolio returns of preferreds (represented by the S&P/TSX Preferred Share Index) to changes in interest rates, we found that preferreds in Canada have a historical duration estimate of -1.7.  This means that if interest rates were to rise by 1%, preferred prices would be expected to fall by 1.7%.  On the contrary, common stocks (represented by the S&P/TSX Composite Index) have a positive relationship with interest rate changes, with the historical duration estimated to be 15.5.

Using these duration estimates, we can look at how well interest rate changes have predicted the returns of the S&P/TSX Preferred Share Index during the time periods below.

Sources: S&P Dow Jones Indices, Bank of Canada.  Duration estimate using data from Dec 2004 – Dec 2013 using monthly returns.  Portfolios are regressed against the 10-year Bank of Canada benchmark yield.

From the table above, we are able to see that the long-term historical duration estimate correctly projected the direction of the period return;but in all three time periods, the actual return was of greater magnitude than the expected return.  What is the reasoning for this?  Other factors besides interest rates also affect preferred prices. Some of these factors include company performance, call provisions of the specific share class, and the required credit spread of the preferred asset class above risk-free assets.  In 2013, the anticipation of future hikes to the target overnight rates in the U.S. and Canada also put negative pressure on the prices of preferreds.

Looking at the performance of each preferred share type in 2013 using the S&P/TSX Preferred Share Index, fixed rate preferreds performed the worst and floating rate preferreds performed the best.  Fixed perpetual preferreds carry the highest interest rate risk (i.e. duration), given that they have no set maturity date.  So it is no surprise that when interest rates rose in 2013, fixed preferreds had the lowest average price return.  The table below breaks down the average return for each preferred type for 2013.

Source: S&P Dow Jones Indices.  Data from Jan 2013 – Dec 2013.

A preferred investor that seeks to mitigate the effects of increasing interest rates could look at shorter duration securities, such as floating-rate or rate-reset preferreds.  In 2013, where the markets saw increased rates, the S&P/TSX Preferred Share Laddered Index which is composed solely of rate-reset preferreds, had a total return of +0.88%.  The laddered index outperformed the S&P/TSX Preferred Share Index (total return of -2.64%) by 352 basis points.