Indexology^® Blog

Brazilian equity market experienced a significant pullback during the month of May due to political concerns.  The correction amounted to being the worst one-day drop since Dec. 30, 2009.  On May 18, 2017 alone, S&P Brazil BMI dropped 8.85%.  On the same day, the S&P/BOVESPA Low Volatility Index posted -5.72%, over 300 bps less than the underlying market-cap-weighted index.

The lower losses posted by low risk indices are not surprising.  It is well established that low volatility strategies deliver higher risk-adjusted returns than the broad-based, market-cap-weighted benchmark over a long-term investment horizon.  Low volatility strategies tend to go down less than the market, thereby offering downside protection while providing a degree of upside participation in an up market.  The efficacy of the strategy has been demonstrated not only in developed markets,[1] but also in Brazil.

Brazilian market participants concerned about equity market volatility can express their views through low volatility strategies.  The S&P/BOVESPA Low Volatility Index, launched on April 30, 2015, is designed to track the performance of the top quartile of securities in the Brazilian equity market that have the lowest volatility.

Exhibit 1 and Exhibit 2 highlight the performance of the S&P/BOVESPA Low Volatility Index compared to the underlying market during the month of May.  While the underlying broad market posted -3.74% (TR), the low volatility strategy experienced positive returns of 1.04%, delivering nearly 480 bps of excess returns.

The behavior of the S&P/BOVESPA Low Volatility Index compared with the underlying benchmark is not exclusive to just May 2017; we have similarly observed lower drawdowns than the market through time.  Exhibit 3 shows the three worst drawdowns during the index history, from Dec. 30, 2009 to May 31, 2017.  In all three cases, the low risk strategy posted lower losses than the market.

Because they experience lower drawdowns than the underlying market, low volatility strategies generally have less to make up for on the upside.  Therefore, over a long-term investment horizon, low volatility strategies tend to deliver higher returns than the benchmark.  We observe the same effect in Brazil, with the S&P/BOVESPA Low Volatility Index outperforming the benchmark (see Exhibit 4).

[1]   http://spindices.com/documents/research/research-is-the-low-volatility-anomaly-universal.pdf

The bond markets are certainly not “Lost in Space”¹. There is good rationale as to why the bond markets are in the position they are today; compressed spreads are the result of low rates coupled with strong demand out pacing supply for yield assets.   However, the homogenization of the US corporate bond markets is worrisome and should begin to raise some eyebrows in the junk bond markets.  What am I worried about? Credit spreads widening.

Chart 1: The S&P 500 BB High Yield Corporate Bond Index spread to the S&P 500 Investment Grade Corporate Bond Index:

Some rationale behind the angst:

• Elevated risk vs. potential reward
• Size of market. The S&P U.S. High Yield Corporate Bond Index has grown in market value from $715billion in December 2006 to over $1.5trillion in June 2017.
• More than half of that index, by market value, is comprised of consumer discretionary, energy, telecom and materials related issuers.
• Weakness in consumer discretionary. The drumbeat of bad news in the retail consumer discretionary markets: stores closing, companies closing, downsizing or reorganizing. The S&P U. S. High Yield Consumer Discretionary Bond Index tracks over $304billion in market value.
• Oil. The S&P U.S. High Yield Energy Corporate Bond Index tracks over $233billion in market value of bonds from the energy sector.
• Competition in telecommunications. The S&P U.S. High Yield Telecommunication Corporate Bond Index tracks over $132billion in market value.
• Materials. The S&P U.S. High Yield Materials Corporate Bond Index tracks over $142billion.

Chart 2: Select indices and their yields over time:

The past is not prologue and no one has ever seen this type of market before. Monitoring the spread risk in the high yield sectors seems prudent at this juncture.

¹Lost in Space was a 1960’s sci-fi television series of the Robinson family traveling through space. The protagonist son, Will, was protected by a robot who would warn him of pending danger by waiving its arms and saying “Danger, Will Robinson”.

For more information on S&P’s bond indices including methodologies and time series information please go to SPDJI.com.

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Recently, the S&P BSE SENSEX closed above 30,000 (and 31,000 as of 26^th May 2017) for the first time, recording a lifetime high in its 31 years of live history.  Immediately, print and online media were flooded with news articles discussing various milestones of the S&P BSE SENSEX.

There were columns explaining how market participant wealth grew over the past 30 years, comparing different asset classes (equity, fixed income, gold, etc.), with the S&P BSE SENSEX being used as proxy for equities.  What amazed me is that almost all of them used the price return (PR) version of the S&P BSE SENSEX, completely missing out on the cash dividend component.  The version of the S&P BSE SENSEX that is tracked on television or in newspapers is the price return index, which is designed to measure only the capital appreciation (price change) of its constituents.  Like all S&P BSE indices, the S&P BSE SENSEX also has a total return version that measures not just returns from price change, but also returns earned due to cash dividends and their reinvestment, called the S&P BSE SENSEX Total Return (TR).  The cash dividends earned are assumed to be reinvested in the index as of dividend ex-date.

The TR version of S&P BSE SENSEX starts from 19^th Aug 1996. The first TR value is exactly same as PR value i.e. 3,281.49 as of 19^th Aug 1996. The S&P BSE SENSEX index close value of PR and TR versions as of 26^th May 2017 (first time when S&P BSE SENSEX closed above 31,000) is 31,028.21 and 43,778.32 respectively. This shows power of compounding of reinvestment of dividends.

Exhibit 1: S&P BSE SENSEX and S&P BSE SENSEX 50 Index Performance 

Source: Asia Index Pvt. Ltd.  Data from May 29, 2007, to May 26, 2017.  Index performance based on price and total return in INR.  Past performance is no guarantee of future results.  Charts are provided for illustrative purposes and reflect hypothetical historical performance.  The S&P BSE SENSEX and S&P BSE SENSEX 50 were launched on Jan 2, 1986, and Dec 6, 2016, respectively.

Source: Asia Index Pvt. Ltd.  Data from May 29, 2007, to May 26, 2017.  Index performance based on price and total return in INR.  Past performance is no guarantee of future results.  Table is provided for illustrative purposes and reflects hypothetical historical performance.  The S&P BSE SENSEX and S&P BSE SENSEX 50 were launched on Jan 2, 1986, and Dec 6, 2016, respectively.

Why Is It Important to Take Note of the TR Index?

Equity investments generally generate returns from two sources—capital appreciation (or price changes) and cash dividends.  In order to have a fair, apples-to-apples comparison, it is important to compare the portfolio returns with the TR version of the index.  For instance, if an investor with a single-stock portfolio compares the returns earned from the portfolio with the returns from the S&P BSE SENSEX (PR), it would be an unfair comparison.  Apart from capital appreciation, the portfolio returns include cash dividends earned.

Source: S&P Dow Jones Indices LLC.  Table is provided for illustrative purposes.

In Exhibit 3, we can see that if we compare stock A’s total return of 12% with the index’s price return of 10%, we would falsely assume that stock A outperformed the index; however, when the same is compared with the index’s total return of 13%, we realize that stock A underperformed.

As TR includes not just PR, but also cash dividends, the TR index will be always be higher than the PR index, because cash dividends can’t be negative.

To conclude, it is absolutely fine to track the PR index on a daily basis.  However, it may be a good idea to use the TR index when one has to measure or compare the returns or performance of asset(s) and scheme(s) with an index, as it is the TR version that would more closely represent what a market participant would take home.

To learn more about TR index calculation, check out Index Basics: Calculating an Index’s Total Return.

The recent ratings downgrades by both Moody’s and S&P Global Ratings have placed the State of Illinois general obligation bonds on the edge of becoming junk.  As of this writing, the ratings are Baa3/BBB-/BBB by Moody’s, S&P and Fitch.

The fiscal struggle endured by Illinois has indeed been a long one, now yields for Illinois G.O.s have finally begun to widen with the impetus of the downgrades. While there has been a spread between investment grade bonds and Illinois G.O.s  the muni market kept the yields for these bonds relatively consistent up until now.  Yield blindness or stated another way, the insatiable search for yield coupled with the low supply of higher yielding bonds has kept many weaker credits including Illinois from seeing higher spreads.

Chart 1: Yields of the S&P Municipal Bond Illinois General Obligation Index and the S&P Municipal Bond Investment Grade Index:

S&P Dow Jones Indices tracks approximately $8.5billion of State of Illinois G.O.s in our indices. The table below provides a snapshot of the percentage those bonds represent.  Note: Under S&P Dow Jones Indices methodology, the lowest rating determines if the bonds remain in the investment grade indices or are shifted to the high yield category.

Table 1: Percentage of total par value the State of Illinois G.O. bonds represent in select indices:

For more information on S&P’s bond indices including methodologies and time series information please go to SPDJI.com.

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As of June 5, 2017, the yield of Indian sovereign bonds, as tracked by the S&P BSE India Sovereign Bond Index, stood at 7.03%—the second-highest sovereign bond yield among the Pan Asian countries, following that of Indonesia, at 7.09%. The yield of the S&P BSE India Sovereign Bond Index climbed 19 bps YTD as of the same date, though it was still at a seven-year low (see Exhibit 1).   RBI has cut rates six times since January 2015.

Indian sovereign bonds currently represent 70% of the overall Indian bond market. Their total market value expanded fivefold to INR 52.7 billion in the past 10-years, outpacing the growth of the corporate bond market, which doubled to INR 24.2 during the same period.  Among corporate bonds, the biggest sector was financials, which represented 9% of the S&P BSE India Bond Index, while other sectors like services, utilities, and industrials contributed around 1% to the overall market.

Although the S&P BSE India Bond Index jumped 13.22% in 2016, Indian bonds have been lagging other Pan Asia countries in 2017; the index advanced only 1.71% YTD as of June 5, 2017. Looking at the risk/return profile in Exhibit 2, all indices have consistently delivered solid returns, in the range of 8% to 10%.  It is interesting to note that the S&P BSE India Corporate Bond Index had lower risk than sovereign bonds during all periods studied; this could probably be explained by the Indian corporate bond characteristics, which are relatively fragmented and less liquid than the sovereign bonds.

Exhibit 1: Yield-to-Worst of the S&P BSE India Sovereign Bond Index