Indexology^® Blog

As of Feb. 26, 2015, the U.S. corporate bond market was valued at USD 8.3 trillion.[1]  For comparison, that’s larger than the GDP of Germany, France, and the U.K. combined.  Exhibit 1 details the growth of the U.S. corporate debt market since 2009, showing annual issuance amounts for both investment-grade and high-yield debt.  Since 2012, there has been USD 1.3 trillion[2] of U.S. high-yield corporate debt issued—more than the total amount issued in the prior 10-year period (2002-2011).

Given the low interest rate environment and the increased demand for yield, many U.S. corporations have taken advantage of the opportunity to borrow at lower costs.  What is interesting is how increased borrowing may not necessarily contribute to long-term growth.  Rather than investing in assets or technology, many companies used the proceeds from debt issuances to pay dividends or support buyback programs.  As evidence, dividends paid out by companies in the S&P 500^® in 2015 amounted to the highest proportion of their earnings since 2009.

Further, using the constituents of the S&P 500 Bond Index, measures of debt relative to cash flows are at levels not seen since 2008 (see Exhibit 2).

Also noteworthy is the amount of U.S. corporate debt that is scheduled to mature in the next five years.  Recent reports from rating agencies state that as much as USD 4 trillion[3] in U.S.-rated corporate debt is set to mature through 2020.

Of the USD 3.7 trillion of corporate debt tracked by the S&P 500 Bond Index, over USD 1.5 trillion (approximately 40%) is set to mature through 2020 (see Exhibit 3).

While the past six years have been conducive for corporate debt issuance, the current environment of easy monetary conditions may not continue.  As seen with the recent turmoil with high-yield debt, the market’s ability or willingness to support debt refinancing is not always present.  As credit concerns escalate, corporations may face the possibility of increased funding costs or limited refinancing options.

[1]   Source: SIFMA

[2]   Source: SIFMA

[3]   Source: Standard & Poor’s Ratings Services Credit Services Ratings & Research (RatingsDirect^®)

In spite of the complex and volatile global markets, the Mexican government issued bonds in the international market for the second time this year.  In January 2016, it issued USD 2.25 billion in bonds with a coupon of 4.125%, and on Feb. 16, 2016, it issued two other types of bonds denominated in euros, totaling € 2.5 billion, or approximately USD 2.8 billion.  All of this adds up to a total of USD 5 billion, which represents 80% of the foreign debt financial needs for 2016.

The new bonds issued in euros were issued with a yield close to historic minimums in the euro market.  The first was for € 1.5 billion, with a maturity in 2022, which was offered at a yield of 1.98% and a coupon of 1.875%.  The second was for € 1 billion, maturing in 2031 at a yield of 3.424%, with a coupon of 3.375%.  The demand had a ratio of 1.76, with more than 280 international investors.  According to the Ministry of Finance (Secretaría de Hacienda y Crédito Público), the level of participation showed the trust in public finances and the good management of public debt.  Also, it established new references to provide liquidity to the yield curve in euros.

Considering the bond issuances since 2010, Exhibit 1 illustrates the amount issued in U.S. dollars (taking into account bonds in U.S. dollars, euros, British pounds, and Japanese yen), divided by maturity.  We can see that 44% of the total (USD 20.75 billion) will mature between 2021 and 2030.  Exhibit 2 shows the amount issued by currency and that 61% of the total amount is issued in U.S. dollars.

S&P Dow Jones Indices seeks to track the bond issuances in U.S. dollars with a maturity of over one year with the S&P/Valmer Mexico Government International 1+ Year UMS Index.  Exhibit 3 shows the annual returns of the index for the past five years and the depreciation of the Mexican peso against the U.S. dollar.  We can see that annual high returns are correlated with a depreciation of the currency.

We’ve written at length of the many historical benefits of the low volatility anomaly. The S&P 500 Low Volatility Index selects the 100 least- volatile members of the S&P 500 index; lacking any sector constraints, the index seeks to provide pure exposure to the low volatility factor. In doing this, it has experienced a large tracking error (9.5%) relative to the S&P 500.

Some asset owners are not comfortable with such a large tracking error. While it would be easy to dismiss low vol on the grounds of tracking error, the decision need not be binary.   The chart below plots the tracking errors at various levels of exposure to the S&P 500 Low Volatility index. The remainder of the equity exposure in these points is to the S&P 500. For example, if 50% is allocated to Low Vol, the other 50% is allocated to the 500.

The key takeaway is that tracking error increases proportionally as low vol allocation is increased. Unsurprisingly, the benefit of exposure to low vol increases as allocation to low vol increases.

A fund comfortable with 4% tracking error may resist a 100% allocation to low vol but could still benefit from a 40% allocation.  Historically, that would have provided enhanced return with a reduction in volatility versus the S&P 500. When it comes to low vol, a little exposure goes a long way.

Okay, the mono-line insurance companies aren’t going to enjoy this note.  After all, yields of insured bonds should be lower than bonds that are un-insured.  Prior to the great recession approximately half of the municipal bonds outstanding were insured and during that time insured bonds were more in demand than un-insured bonds.  Beginning with the great recession we have seen yields of insured bonds higher than un-insured bonds as questions about the viability of the insurers themselves were prominent worries in the market place.  It is understood that not all mono-line insurers are the same credit quality, some are stronger than others.  However, in aggregate the impact is impressive.

Using the weighted average yields of bonds in the S&P Municipal Bond Insured Index and the S&P Municipal Bond Investment Grade Index the difference can be highlighted. The result has been yield ‘pickup’ between insured and investment grade municipal bonds as of Feb. 25 2016 was 28bps.  In general, it is cheaper to buy insured bonds than un-insured bonds and as a result returns have been higher.

Chart 1: Select municipal bond indices and their yields and returns over three year period

The risk of generalizing or over simplifying the complex municipal bond market  is inherent in any broad analysis.  Each issuer and each mono-line insurer has their own credit profile. The indices aggregate the bonds to provide the weighted average statistics used.

Lyrics to the Canadian national anthem, “O Canada,” state “The true north strong and free!”  Like in the U.S and many other countries, government and corporate debt has become a big issue in Canada.

The Canadian overnight rate stands at 0.5% and will most likely remain unchanged or decrease even more.  Central Bank Governor Stephen Poloz’s decision on Jan. 20, 2016, to keep the benchmark rate at 0.5% halted a slide in the currency.

With rates so low, governments have been looking to more than just monetary policy to stimulate their economies.  The newly elected Canadian government has looked to infrastructure spending as a way to grease the economic skids.  Prime Minister Justin Trudeau said the federal government would fast-track infrastructure spending.

The newly elected liberal government said the deficit could swell to CAD 30 billion in the 2016-2017 fiscal year amid a starkly weaker outlook for the economy.  Such a large deficit would be 1.5% of GDP.  Compared to the amount of debt the U.S. carries, with obligations to other countries such as China, Canada’s AAA rating and debt amount look pretty good, but investors should be aware that the situation is and will be changing.  Larger amounts of longer-term debt may make the Canadian indices more sensitive to interest rate movements.

Exhibit 1 shows the percentage changes in the Canadian dollar amount of debt for each fixed income asset class for 2015.  The amount of debt outstanding for 2016 is expected to grow as the new government’s policies are put into place.

Exhibit 1: Index Increases of Market Value

Source: S&P Dow Jones Indices LLC.  Data as of Dec. 31, 2015.  Past performance is no guarantee of future results.  Chart is provided for illustrative purposes. *Globe and Mail, BoC holds rates; bets stimulus, global gains will ease economic pain, Barrie McKenna, January 20, 2016.