Indexology^® Blog

There is a growing debate among economists, journalist and bloggers over whether the Fed’s QE3 is creating a bubble in the stock market. (See Krugman, Gillian Tett or Felix Salmon among others) fueled by the market’s gains since the start of the year and the usual worries that disaster will strike during the summer break at the beach.  There are optimists: some say that “Sell in May and Go Away” should be “Buy in May and Make Hay.”  Virtually all agree — correctly — that the Fed’s low interest rates and QE3 policy is boosting stock prices. Further, all also agree, again correctly, that the Fed will sooner or later stop QE3 (or QE4 or QE5) and interest rates will rise. Rising interest rates are usually not the best medicine for the stock market although they don’t spell complete or immediate doom.   Even with the Fed, QE3 and maybe some more QEs, the bubble fears look overdone from here.

First, a bubble is more than anything that results in a crash and collapse.  A bubble usually builds itself on speculative mania as it departs from any link to funamental financial factors.  As the bubble worriers themselves demonstrate, there are plenty of people worrying that the market will collapse and very few expecting it to rise forever more from here.  We’re not seeing genuine specualtive mania, at least not yet.  Remember “Home Prices Never Fall” or recall names like Pets.com?  Little of that is being seen in the market now. Second, while low interest rates are boosting stock prices, that is a fundamental financial factor making stock more attractive.  Of course, the key part of any bubble is when it bursts.  Bursting bubbles cause damge because they change the state of the world and because they pop when no one is expecting it.  Possibly the only thing being watched more carefully than the Dow and the S&P these days is the Fed. And, unlike either the Dow or the S&P, the Fed can send out warning signals — and probably will when the time comes.

Where does all this leave us? Even without bubbles the market can go down.  We used to call those disappointments corrections.  The market is still as unpredicatable as ever so one need not believe every voice of doom that bubbles up.

U.S. Municipal Bonds: (Data as of May 16,2013)

Corporate junk bond yields have risen as mutual funds have seen outflows. Meanwhile, municipal high yield bonds have held their own. A rare twist in the markets may be ending as a result: yields of tax free high yield municipal bonds are 34bps higher (Yield to Worst) than high yield corporate bonds. That spread has narrowed from last week’s 56bp spread.

High yield corporate bonds tracked in the S&P U.S. Issued High Yield Bond Index have returned just under 5% year to date but lost ground the past several days as fund outflows weigh on the market driving prices down and the weighted average yield (yield to worst) up by 22bps since last week to end at 4.88%.

High yield municipal bonds tracked in the S&P Municipal Bond High Yield Index have seen a 3.9% year to date return with yields remaining fairly steady this week to end at 5.22%.
o The Taxable Equivalent Yield of these same municipal bonds is over 8% when using a 35% tax rate.

The S&P National AMT-Free Municipal Bond Index is up 1.26% year to date modestly outperforming investment grade corporate bonds tracked in the S&P U.S. Issued Investment Grade Corporate Bond Index which has returned just under 1%.

The 5 year range of the municipal bond curve is keeping up with the overall market as the 5 year S&P AMT-Free Muni Series 2018 Index has returned 1.14%, while longer municipal bonds in the S&P Municipal Bond 20+ year Index have recorded a total return of 2.14% year to date with yields remaining steady over the course of the week.

Puerto Rico hasn’t left the spotlight and bonds from Puerto Rico have performed like the high yield market returning 3.77% year to date.

The index is up 0.42% month-to-date.  Here is a performance review of the top & bottom 10 issues within the index.

Top 10 Issues

• May has been a good month for MBIA so far.  The insurer settled a 2008 legal dispute with Bank of America concerning bad mortgage debt.  The $1.7 billion settlement later led to a Standard & Poor’s rating upgrade, which moved the issuer’s senior unsecured debt from B- to BBB.
• Momentive Performance’s first quarter results of slightly lower sales but improving operating incomes, coupled with refinancing activities for a $270 million asset-based revolving loan and a $75 million revolving credit facility, moved this issuer’s bonds up.
• TXU bonds improved as Energy Futures Holdings Corp. looks to win support for a bankruptcy restructuring deal. 

Bottom 10 Issues

• Cengage’s CEO has publically announced that the company may need to file for Chapter 11 and that no decision on a restructuring has been made.
• Physiotherapy Associates is in monetary default as a coupon payment has been missed.
• Harrah’s Operating Company bonds dropped as Ceasars Entertainment missed estimates due to revenue declines in their main markets.

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.