Indexology^® Blog

Following months of uncertainty, the U.S. Federal Reserve has indicated that there could soon be a hike in the Federal Funds Target Rate.  Interest rates have been kept in a range between zero and one-quarter of a percent since December 2008 and have not risen since June 2006.

As interest rates have been at historically low levels for nearly the last seven years, some fixed income investors have shifted their focus to senior loan securities with floating-rate characteristics, such as interest rate floors, to protect themselves in the event of falling rates.  Interest rate floors protect the loan interest rate by increasing the loan interest rate to the spread plus the floor if the reference rate ever falls below the floor.  Simply put, the formula for loan rates in these structures can be stated as follows.

Loan Interest Rate = Maximum of (Reference Rate or Floor) + Spread

As of Nov. 28, 2015, the S&P/LSTA U.S. Leveraged Loan 100 Index consisted of 100 senior loans, of which 91 had interest rate floors based on the Federal Funds Target Rate.  Of those loans, 31 had a floor of 0.75%, 55 had a floor of 1.00%, and 5 had a floor of 1.25%.  As the Federal Funds Target Rate is currently below these floors, we know that the loan interest rates are currently established by the interest rate floors instead.  This implies that as interest rates begin to rise, we may not see an immediate impact on senior loans with interest rate floors.  Lenders may have to wait until the Federal Funds Target Rate rises above 0.75% for the rising interest rates to make a significant impact on this basket of loans.

Much has been written about dividends in academic literature. There are several theories regarding the dividend policies of companies. One theory asserts that dividends are irrelevant because an investor who wants cash flows could sell shares. Another theory suggests that a bird in the hand is worth two in the bush, meaning that investors prefer cash dividends over uncertain capital gains. There are other arguments that take into account the tax treatment, in which investors would prefer dividends to capital gains if dividends were taxed favorably. In India, dividends are non-taxable in the hands of the recipient. As mentioned in a prequel to this article, India has historically had a lower dividend yield in comparison with developed nations. Moreover, Indian large- and mid-cap companies have exhibited more stable dividend yields in comparison with small-cap companies. Let’s take a closer look at the large-cap segment of the Indian market.

From Exhibit 1, we can see that the majority of Indian companies in the S&P BSE LargeCap have paid dividends between 2005 and 2015. The S&P BSE LargeCap is designed to measure the top 70% of companies in the S&P BSE AllCap, based on the cumulative average daily total market capitalization of the included companies over a one-year period. In general, companies prefer not to reduce or omit dividends, as it is perceived negatively in the capital market. This has been noted in the past when the aggregate dividend paid by the companies in S&P BSE LargeCap has either increased or remained the same. This occurred even during the 2008 global financial crisis, although the number of non-dividend-paying companies also slightly increased during this period. More recently, during fiscal year 2015, the aggregate dividends paid have decreased in the S&P BSE LargeCap.

Exhibit 1: Dividend-Paying History of Companies in S&P BSE LargeCap

Source: S&P Dow Jones Indices LLC, Factset.  Data as of Aug. 31, 2015.  Past performance is no guarantee of future results.  Chart is provided for illustrative purposes. 

From Exhibit 2, it can be observed that the majority of the dividend-paying companies in the S&P BSE LargeCap have had a dividend payout ratio (DPR) range of 0%-40% in the 10-year period ending in 2015. More recently, the percentage of dividend-paying companies with a DPR greater than 40% has increased. Companies have negative earnings when DPR is less than 0%, and if it is greater than 100%, then companies have paid out more than they have earned in that fiscal year. In addition, we can note that there were few companies in the S&P BSE LargeCap with a DPR of either less than 0% or greater than 100%.

Exhibit 2: DPR History of Dividend-Paying Companies in the S&P BSE LargeCap 

Source: S&P Dow Jones Indices LLC, Factset.  Data as of Aug. 31, 2015.  Past performance is no guarantee of future results.  Chart is provided for illustrative purposes.

Different classes of investors have different preferences for dividend income. Some may prefer companies that have paid stable or increasing dividends over those that either do not pay dividends or have an unstable dividend payment history. However, dividend increases do attract attention in the capital markets. Together with S&P Dow Jones Indices, Asia Index Private Limited recently launched the S&P BSE Dividend Stability Index. It is designed to measure the performance of companies in the S&P BSE LargeCap that have paid ordinary dividends of 4% or more for at least seven of the past nine years, and the most recent DPR should be between 0% and 100%.

Exhibit 3 details the performance characteristics of the S&P BSE Dividend Stability Index over the 10-year period ending Sept. 16, 2015. The highest excess positive returns over the S&P BSE SENSEX were observed during the 2008 global financial crisis. This is consistent with the results we obtained earlier when we noticed that aggregate dividends paid by companies in S&P BSE LargeCap did not decrease during that period. The capital loss suffered was marginally offset by dividends. Over the same 10-year period, the S&P BSE Dividend Stability Index has provided a CAGR of 15.22%, which is 1.64% in excess of the S&P BSE SENSEX.

Exhibit 3: Performance Characteristics of the Indices 

Source: S&P Dow Jones Indices LLC, Factset.  Data as of Sept. 16, 2015.  Past performance is no guarantee of future results.  Charts are provided for illustrative purposes and reflect hypothetical historical performance.

Many strategies exist worldwide in which investors focus on dividends. With the Indian economy growing at a fast pace and the capital markets maturing, Indian investors may also seek to benefit from them.

The yield-to-worst of the S&P/BGCantor Current 10 Year U.S. Treasury Index averaged 2.26% for the month of November.  The index started the month at 2.15% and closed the month at 2.22%.  At one point on Nov. 9, 2015, the yield was as high as 2.35%, and the index ended 8 bps wider overall.

The anticipation of a Fed interest rate hike on Dec. 16, 2015, and general U.S. economic improvement had the majority of bonds in the red for the month.

The S&P 500^® Bond Index lost 0.28% for November, while it kept the YTD return in the green, at 0.25%.

Energy was the sector that lagged the most, as the S&P 500 Energy Corporate Bond Index was down 4.42% YTD.

All sector indices of the S&P 500 Bond Index underperformed, except for the S&P 500 Financials Corporate Bond Index and S&P 500 Telecommunication Services Corporate Bond Index.  These indices were positive for November but did not return much, coming in at 0.09% and 0.03%, respectively.

Outside of the S&P 500 Bond Index, the S&P Taxable Municipal Bond Select Index was the positive performer of the S&P U.S. Aggregate Bond Index, with a 0.47% gain for the month.

Exhibit 1: Performance of the S&P 500 Bond Index and S&P 500 U.S. Aggregate Bond Index

Source: S&P Dow Jones Indices LLC.  Data as of Nov. 30, 2015.  Past performance is no guarantee of future results.  Table is provided for illustrative purposes.

The Fed’s policy makers, the FOMC, meet on December 15th and 16th and are widely expected to raise the target Fed funds rate for the first time since 2006.  The odds of a 25 bp increase in the target range to 25-50 bp is about 77% based on Fed Funds futures.  There are two key economic reports still expected before the meeting: employment and inflation.

The first chart shows the monthly change in payroll employment since 2009.  The market expectation is for a 200,000 increase, in line with recent numbers and further confirmation that the weakness seen in August and September is behind us.

The second chart shows the core rate for the CPI (CPI ex-food and energy). While the FOMC looks at a similar measure, the personal consumption expenditure deflator, the CPI is more widely followed and will be released on Tuesday, December 15th as the FOMC members gather for their meeting. It is expected to show inflation remains below the Fed’s 2% desired figure.

For those who wonder why there is so much interest in the Fed and a possible turn in interest rates, the last chart of the 10 year Treasury note yield is a capsule history of the bond market since the 1960s.  We are nearing the end of what used to be called the “Great Intergalactic Bond Rally.” Once the Fed begins the shift to rising rates, it will be a different financial world.

Unfortunately for commodities, there’s no waking up from this nightmare. It’s real. Since 1970, the S&P GSCI has never seen a Nov. with as many as 21 negative commodities. After a glimmer of hope in Oct., only 3 commodities, sugar, cotton and cocoa are on track to be positive in Nov. In other words, for every one commodity that is positive, seven are negative in Nov., 2015.

Moreover, Nov. 2015 is the 5th worst Nov. on record since 1970, only behind 1997, 1998, 2008 and 2014. Year-to-date, the index is also on pace to be the 5th worst year with 1998, 2001, 2008 and 2014 losing more. Though YTD through Nov. 2014, the index was in better shape than the index is through this Nov.

While 2015 is not the worst year for any single commodity despite 2 down more than 40%, 7 down more than 30% and 13 down more than 20% (more than half in a bear market for the year), there are a number of commodities setting notably bad years. Aluminum, feeder cattle, Kansas wheat, nickel, and the industrial metals sector are all posting their worst years after 2008. Below is a table showing the rank of worst years since 1970 (for example, aluminum is having its second worst year in history and gold is having its sixth worst year in history):

Last, it is worth mentioning that 20 of the 24 commodities are in contango. Although this is the highest number since Nov. 2013, there have been 23 other months in history where 20 or more commodities have been in contango together. However, November is the worst month on average of any of the twelve months for having the most commodities in contango. It is the only month that has more than half on average (12.4) in contango, and of the 24 months in history having 20 or more commodities in contango, 7 have occurred in the month of November. Contango has had a significant cost, erasing almost an additional ten years of gains, for commodity investors rolling the first nearby most liquid contracts. Notice the spot index is only at the Feb. 2009 level, while the total return is at the Jun. 1999 level.