Indexology^® Blog

I am sure you have probably heard of, or even tried the Cantonese delicacies dim sum. While many people have a good knowledge of Barbecue Pork Bun or Siu Mai Dumplings, not many can tell exactly what is in the dim sum bond market.

Dim sum bonds are the debts that issued in the offshore renminbi (CNH) market.  This market was initially developed in 2009 to meet the investment demand from the growing CNH deposits in Hong Kong. Supported by a healthy supply and demand dynamic, it recorded a significant expansion since then. The global investors continue to be attracted to this particular market due to the anticipation of currency appreciation and the exposure to Chinese credits.

As tracked by the SP/DB Orbit Index, the total market value of the most liquid bonds and certificate of deposits (CD) with par amount above CNH 1 billion, is now over CNH 160 billion. The average yield of the index is 4.26% while the duration is 2.6. The index has delivered a total return of 5.28% since it incepted on Dec 31, 2010. If we take into the consideration of currency appreciation, the S&P/DB ORBIT (USD) Index rose 13.52%!

Similar to other markets, the offshore renminbi market is composed of sovereigns and quasi-sovereigns, as well as credits sectors. Under sovereigns and quasi-sovereigns, we have the bonds issued by Chinese government bonds, the four major policy banks in China, as well as the other global central bank, like Korean Development Bank. These bonds represented 39% weighting of the index.

There is also a very diversified issuers profile under the credits sector. For the Chinese properties, there are names like Yanlord and Gemdale. For Chinese corporates, we have some stated—owned corporates such as Shanghai Baosteel and Huaneng Power. There are also more foreign corporates, like Renault and Caterpillar entering into this market; in fact over 25% of the S&P/DB ORBIT index is composed of non-Hong Kong / China domiciled companies. Issuers continued to tap into the CNH market for a few reasons, firstly the offshore market offered a cost benefit compared with the onshore market, however it is no longer the case as the yields gradually converged, the offshore market is now trading around 50bp discount to onshore. Secondly, depending on the cross currency swap, some issuers may find it cheaper to issue in CNH than USD. Lastly, issuers may want to diversify its funding into CNH.

In terms of credit profile, 67% of the S&P/DB ORBIT Index is rated, and of which 55% of them are investment grade rated. While more issues are being rated nowadays, the overall creditworthiness of the market has also been enhanced.

On the other hand, liquidity has significantly improved as the regulatory continues its effort to internationalize the currency while the bond market matures. High yield names, particularly, have been very active this year, due to the high issuance and attractive yields. For example, a one-year paper of RENAULT, rated BB+, is trading about 4.30%. The average yield for high yield credits is around 7.75%, for duration of 2.3.

Perhaps one credit that got most attention recently is I.T. LTD, it is an apparel company found in Hong Kong and rapidly expanding its footprints in mainland China. Its major clienteles are the young Chinese generation with high purchasing power. It is not difficult to witness it when you walk into one of their shops in Shanghai, you can see one cardigan is easily priced in the range of USD 300-400 equivalents and it is bought without blinking an eye. Despite the strong consumer spending, the bond that the company issued at 6.25% in May plunged soon after it issued a profit warning, it is currently trading around 11%.

One thing to note, the S&P/DB ORBIT Index exhibited negative correlation to the U.S. treasury market while it also historically delivered a better risk-adjusted return, thus it provides investors an excellent way to diversify the fixed income portfolio, particularly in the current interest rate environment.

Economists agree that what people expect the future to bring helps determine the economy’s future.  Expect prices to rise? Buy in advance.   Expect everyone to invest in that hot stock?  Go online and buy the stock now. Expect the Fed to keep interest rates so low money is almost free? Take some risks, buy that house or a new car, and buy stocks not bonds.

As central banks around the world sought new ways to stimulate economies in the face of zero interest rates, they (re)discovered the idea of convincing everyone that now is the time to spend because the good times are around the corner.  To make this sound like serious economic theory rather than hucksterism, it is called managing expectations.  It used to be called jaw boning. Moreover, the idea works.  Advertising QE1-2-3 or announcing that the Fed funds rate target would remain zero to 25 basis points until the unemployment rate dropped below 6.5% are key parts of this effort.  The expectation effects have contributed to the economy’s improvement.

One key to managing expectations is not to let anyone know their expectations are being managed.  Once they suspect that some of what they are hearing, and thinking, is there just to convince them, some people will try to out-think the management.  With increasing debate about whether QE3 was working, why it would work and what would come next, people began to wonder exactly what game was being played by whom.   The reaction to the Fed’s comments in May and June and Chairman Bernanke’s June press conference, looked like a reminder that one can fool some of the people some of the time, but not even the Fed can fool all the people all the time.  Once the expectation that interest rates might rise appeared, investors and home buyers tried to front run monetary policy.  This effort – selling bonds before yields climb and prices collapse—caused prices to drop and yields to rise.  The Fed’s response last week was an effort to create new, but temporary, expectations that rates won’t rise quite yet.   Temporary because sooner or later interest rates will rise.

If managing expectations becomes a permanent tool of monetary policy, trying to front run or out-fox expectations will continue.  Investors will listen to the Fed’s comments only to figure out what they Fed wants them to think and do. Then they will do what they think is in their best interests – often the reverse of what the Fed intended.  The result is a circular game of trying to out-guess one-another.

One suggestion for the Fed may be to return to some of its past practices and talk less.  There was a time when the Fed seemed to follow Theodore Roosevelt’s approach to speak softly and carry a big stick.

The Federal Reserve’s decision to continue its monthly stimulus purchases on Sept. 18, 2013, had a euphoric effect on the markets, as the S&P 500 immediately rose from 1702 to 1715, eventually closing the day at 1726. Treasuries reacted to the news in the same way, as yields on the 10-year Treasury went from 2.86% to 2.73%, finally ending the day at 2.68%. The market’s reaction is in stark contrast to the last few months of communication and preparation for a September tapering, as the expected change in policy was already priced into the market. The reasoning behind the Fed’s lack of action could be even more unsettling, as it points to continued weakness in the U.S. economic recovery. The Fed’s stimulus program must end at some point, and the question is when that point comes, will the markets heed the Fed’s communications and be as prepared as they were this go around? With that in mind, fixed income investors should be thinking about how to manage their portfolio in a rising interest rate environment.

Portfolio laddering is a traditional bond market strategy for investors during periods of rising rates. The underlying principle of the strategy is that while rates are rising, re-investment of returning short principal and interest at higher rates negates the negative price action. A ladder strategy can be structured from a variety of fixed-income products, including: Certificates of Deposit, Treasury notes, Agency notes, Municipal notes, and Corporate notes. Credit risk will factor into the selection choice but, depending on the length of the ladder, shorter maturities will have a smaller degree of risk.

The ladder provides better income and total returns when rates are rising than selecting a single security because of the strategies’ ability to re-invest maturing proceeds at more current rates. Creating a ladder strategy begins by combining similar or differing bonds in a portfolio with differing maturities in semi-annual or annual increments. As each bond rolls down the curve and matures, it is replaced by purchasing a similar security in current market conditions at the longest target date of the strategy. A common example would be a one- to five-year annual Treasury bond strategy. A year from now the one-year bond will mature and be replaced with a five-year security. Assuming yields have risen over that year, the five-year security that is added to the strategy will incrementally add yield to the portfolio. If the replacement bond is going to be a Treasury, choose the off-the-run rather than the on-the-run so that you’re not paying for liquidity premium, which is additional richness priced into the on-the-runs due to the demand by the repo markets.

Indices can be a helpful way to study the performance of a ladder strategy. In some cases, the index may have an investible ETF issued against it, which gives an investors access to that segment of the market. The following table shows the current levels of yield within certain fixed income areas.

The US Municipal bond market has bounced off its recent bottom even as two anchors continue to weigh it down: Puerto Rico and tobacco settlement bonds.

Investment grade tax-exempt bonds tracked in the S&P National AMT-Free Municipal Bond Index have seen a 2.32% positive total return since it’s year to date low on September 5^th 2013.  In less than two weeks, the weighted average yield to worst of bonds in the index has fallen from 3.43% to 3.10% or a 33bp improvement.  The S&P National AMT-Free Municipal Bond Index is still in negative territory for the year, down 3.87% year to date.  A drop off in new issue supply and yields reaching more attractive levels have combined to help bring prices back up.

Tracking Puerto Rico municipal bonds since December 1998, the S&P Municipal Bond Puerto Rico Index hit a record high yield on September 9, 2013 with the index reaching a weighted average yield of slightly over 7%.  Since that point, yields have improved by 49bps to end last night at a 6.51%.  As of last night, the yield for Puerto Rico bonds is more than double those of the average seen in the S&P National AMT-Free Municipal Bond Index.  This has been the worst quarter in the index history with a negative 12.68% return and so far the worst performing year with a year to date total return of negative 14.6%.

Tobacco settlement municipal bonds have had a good September so far helping to offset serious losses seen during the quarter.  The S&P  Municipal Bond Tobacco Index has recorded a positive 5.39% during September so far but for the quarter have returned a negative 4.37%.   The index has seen a year to date return of negative 7.66% helping to hold back the returns of the municipal high yield bond market.  The S&P Municipal Bond High Yield Index has seen a positive September month to date recording a positive 2.33% however is still in negative territory for the year with a – 4.7% return year to date.

Five year municipal bonds tracked in the S&P AMT-Free Municipal Series 2018 Index have rebounded as yields have come down by 18bps over the course of the month to end at 1.69%.

The ten year maturity range of the municipal bond market has seen a nice rally.   Ten year municipal bonds tracked in the S&P AMT-Free Municipal Series 2023 Index have seen yields come down by 39bps this month driving a total return of 3.18% month to date.

A more detailed discussion on the municipal bond market is scheduled for October 17th in NYC.  To learn more about attending this complimentary forum please click here.

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– What causes spikes in commodity prices and how regulation is impacting commodity investment in modern market times.
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