Indexology^® Blog

It doesn’t take more than a passing glance at a business publication or televised market update to know that one of the top business stories is the current low interest rate regime.  U.S. Treasury bills are being auctioned, and are trading, at or near zero yields.  The yield-to-worst on the S&P/BGCantor 0-3 Month U.S. Treasury Bill Index is presently at 0.03%. This means the government is financing itself at close to zero cost for its short term borrowing and, further out on the curve, the cost of financing does not go up by much; as the yield-to-worst on the S&P/BGCantor 7-10 Year U.S. Treasury Bond Index is now at 1.48%. As long as the Fed continues to effectively stimulate monetary policy with its monthly purchases of $85 billion in notes and mortgage bonds, this situation will most likely continue.

As the treasury curve is the basis of valuation for most debt, outside of Libor for loans and swaps, the currently advantageous environment applies to other asset classes of the capital markets as well. Corporate debt, as measured by the S&P U.S. Issued Investment Grade Corporate Bond Index, has reached recent lows in May as the index’s yield-to-worst stands at 2.50%. Below investment grade issuers, whose credit risks rating agencies view as a higher concern, and which comprise the S&P U.S. Issued High Yield Corporate Bond Index, are yielding 4.66% (YTW).

Treasurers and CFOs across the market are touting this as the perfect time to refinance and strike deals, as the cost of financing is so low.  Companies are issuing various maturities of debt at a frenzied pace to an investor base that demands as much yield as it can get.  Such “oversubscribed” deals show that investors are piling into both investment grade and high yield paper.  Investors are frantically scooping up any product that provide yield, but are they turning a blind eye to the risks they are assuming?  As companies use these funds to realign their businesses, pay down older debt, start new projects, or create new ones, the benefits of current leveraging will only be determined in the future.  A more immediate effect, among others, has been the buyback of equity shares by a number of companies, as the S&P 500 is up 14.06% year-to-date.

Show me a man who’s never been burned by relying on a backtest and I’ll show you a man who’s never relied on a backtest at all  (either that or a fictional character).  Skepticism toward backtested results is endemic among investment professionals, and rightly so.  And yet… when a new concept comes along, backtested performance may be the only performance available.  Refusing to examine backtested results in that circumstance is tantamount to refusing to consider any new investment idea.

We discuss this problem here: http://us.spindices.com/documents/research/research-the-limits-of-history.pdf, suggesting that skepticism should sometimes extend not only to backtested data, but to live history as well.  Past performance is never a guarantee of future results, but sometimes it’s more useful than other times – whether its source is real or simulated.

A performance review on the two major commodity indices in the market — the S&P GSCI and DJUBSCI. Find out the main themes that has been driving commodity performance since the beginning of 2013.

The S&P National AMT-Free Municipal Bond Index is up 1.25% year to date improving by 0.91% so far in April. Exactly where we were at the end of last week.

The ‘belly’ of the curve, or the 5 to 10 year maturity range, is performing as well as longer term bonds as the weighted average yield of bonds in the 5 year S&P AMT-Free Muni Series 2018 Index have come down by 11 bps in April, exactly where we were at the end of last week, to return 1.21% year to date.  Ten year bonds in the 2023 Index have improved by 25bps to end at a weighted average yield of 2.25%.

Even with a slip of 3 bps to the cheaper since month end, the high yield municipal bond market tracked by the S&P Municipal Bond High Yield Index remains on track to making April the 17th consecutive month in a row where it has seen a positive monthly return. Year to date the high yield municipal bond market has returned 2.88% with April contributing 0.75% so far. The yield to worst of these bonds is a 5.27% (tax-free) while investment grade corporate bonds in the S&P U.S. Issued High Yield Corporate Bond Index have a weighted average yield to worst of 5.04% (taxable).

Comparing municipal bonds to other asset classes:

The S&P U.S. Issued High Yield Corporate Bond Index is returning 4.01% year-to-date with a weighted average yield of 5.78%.  Similar to high yield bonds—whose credit ratings are below the investment grade cutoff of ‘BBB’ assigned by the rating agencies—are senior loans. William Shakespeare’s famous quote from Hamlet, “To be, or not to be, that is the question” can be rephrased by investors comparing high yield to senior loans as “secured, or unsecured, that is the question,” when pondering the risks of each product. Senior loans rank higher in the capital structure and are secured to the assets of the business, unlike the unsecured nature of high yield bonds. The loan’s coupon is typically the higher of a floor rate or a certain spread over three-month LIBOR. Because their coupons are tied to a short-term rate, senior loans have less interest rate risk and are considered a floating rate instrument. In a rising rate environment, senior loans are at an advantage to high yield whose bullet structure and fixed coupon would be negatively affected. Not surprisingly, senior loans tend to have slightly smaller, but less volatile returns than high yield bonds (See Total Returns table).

When investing in lower rated credit instruments, the risk of default should always be a concern. Though now, after the 2008 financial crisis, the majority of companies have put their balance sheets back in relatively good financial shape. Presently, default rates are near historical lows, with senior loan defaults at 1.4% and high yield defaults at 2.3%.

Weighing the risks, both senior loans and high yield bonds are attractive investments. Not only because of their higher yields, but also because they are relatively short investments which, when compared to other long term investments, won’t be as affected by changes in long term rates. The duration of the S&P U.S. Issued High Yield Corporate Bond Index is 5 years, while the average life of senior loan is 4.48 years as measured by the S&P/LSTA U.S. Leveraged Loan 100 Index.

An additional benefit of these two investment choices is that their returns are negatively correlated to other markets, so as one product is underperforming the other is providing return (See Correlation Table).