Indexology^® Blog

The story plot thickens for Puerto Rico bonds as Moody’s placed bonds issued from Puerto Rico under review for a possible downgrade to below investment grade.  Selling pressure continues to mount impacting the market.  The S&P Municipal Bond Puerto Rico Index has seen a negative total return of 19.45% year to date and the weighted average price of bonds in the index has fallen by over 24% this year.   The weighted average yield (YTW) of bonds in the index ended at 7.26% or  419bps higher than investment grade bonds.

Investment grade municipal bonds tracked in the S&P National AMT-Free Municipal Bond Index have seen a negative 3.21% return year to date. Secondary trading in the muni market tends to get lighter before and after the holidays and it is still wrestling with a  heavy new issue calendar.

Tobacco settlement municipal bonds also have been weaker.  The S&P Municipal Bond Tobacco Index has declined by 8.96% year to date.  The index tracks over $82billion in par value of tobacco settlement bonds.  Yields on these bonds have risen 267bps over the course the year to end at 6.89%. These high yield, long duration bonds are impacted by both credit risk driven by declining tobacco use and the possibility of rising rates.

Volatility can feel like an earthquake.

As many investors can painfully testify, the chart below is typical of volatility.  A period of relative calm is disturbed first by a few small tremors, then by a precipitous rise.  At this point, risk breaks all connections with its normal level and climbs rapidly to a crystalized zenith of distress and chaos … before declining, at first rapidly then slowly; rollercoasting through a cascade of aftershocks as the grind back down to normality occurs.

Note: Chart courtesy of Groundswell Earthquake Outreach

Volatility can feel like an earthquake, and it’s far from simply a romantic metaphor.  As the reader may have already guessed, the chart above is not from any financial market. In fact it shows the measured magnitude of foreshocks, aftershocks and the actual ‘Great East Japan Earthquake’ at Tohoku on March 11^th, 2011. The reading of 7.1 immediately subsequent to the main spike is better known, resulting ultimately in the failure of the nuclear plant at Fukushima.

The statistical properties of earthquakes are the subject of much serious academic research, the fruits of which allow for empirical predictions of the number, magnitude and frequency of aftershocks.  In 2010 a group of physicists tested these sharpened tools on market volatility, with a remarkable degree of success.   Put simply, the statistical rules that explain earthquakes also fit and predict the patterns of stock market volatility.

Such analytic dissections are certainly interesting to options and volatility traders.   And these relationships provide the rest of us with a deeply meaningful analogy for the judicious management of risk.  If you live near a fault line, take very close heed of tremors; immediately after an earthquake, prepare for the aftershocks accordingly. 

On December 11^th, after the market closed, S&P Dow Jones Indices announced that Facebook will  join the S&P 500 as of the market open on Monday, December 23^rd.   This was probably one of most predicted, asked about and commented on additions to the S&P 500 in the last few years, Measured by the number of suggestions to (or demands of)  the index committee, Facebook ranks with other tech darlings including Google, Yahoo and AOL.

Facebook closed at $49.38 on December 11^th before the index announcement and opened at $51.04 on December 12^th, an overnight gain of 3.4%.  The move is similar to other recent index additions, but is a good deal lower than some of the overnight jumps seen in the past.  Most likely market participants were expecting an announcement on Facebook – one analyst predicted it shortly before the announcement of General Growth Properties as the replacement for Molex a couple of weeks ago.

Wall Street analysts and bankers ask about index additions because they are guessing who will be next. Their questions are Why this one? Why now? Did you worry about being under-weighted in that sector?  Some answers –

Why Facebook? The S&P 500 is often termed “leading companies in leading industries.”  Facebook is certainly a leading company in internet software and services which is definitely a leading industry. No one suggested that it should not have gone in. Why Now? Two factors: our guidelines require four quarters of positive earnings according to GAAP and Facebook only reached this last fall. Second, this is a large company and we wanted a date with a lot of trading and liquidity.  The third Friday of the last month of the quarter, when futures and options expire, is such a day.  Were we worried about sector weighting?  It was not the primary factor in this decision.  Who’s next? Stay tuned.

Tracked by the S&P/ASX Corporate Bond Index, the size of the Australian dollar denominated corporate bond market currently stands at 57 billion, which is one-tenth of the broader benchmark, the S&P/ASX Australian Fixed Interest Index. While the corporate sector is relatively small in Australian bond market, the size actually grew more than 80% since the index incepted in 2005.

In fact, if we trace back to the history, the corporate bond market has undergone a vast development. Since the early 80s, there was a transition from predominantly publicly owned issuers to private issuers. Driven by the deregulation of the financial system and removal of capital control, a solid growth in corporate bond market, particularly bank bond issuance, was observed.

Although some corporate issuers are attracted to the offshore market, as to minimize and diversify their funding cost and also to match their foreign currency revenue streams, it is also witnessed there is a strong investor demand in the corporate bonds denominated in Australian dollar.

Benefited from the continuous hunt for yield, the S&P/ASX Corporate Bond Index delivered a robust total return of 3.95% year-to-date (YTD), as of December 5, 2013. The corporate bonds outperformed the market, compared with the 0.09% YTD gain of S&P/ASX Government Bond Index. The yield to maturity grinded 20bps tighter to 4.31%, it is appealing in this low rate environment and considered the minimum credit rating for index inclusion is BBB-/Baa3/BBB-.

The investor appetite for the risk-adjusted return is also reflected in the tightening spread to the Australian government bonds. As shown in Exhibit 1, the spread has already contracted from 1.37 a year ago to currently 0.65 level, which is also the tightest level that spread reached in 2006. It means the investors are now accepting a lower relative yield to own the risker asset.

Perhaps it seems to hint that investors are now ready for the further expansion in corporate bond market…

Google’s expected stock split has focused attention the treatment of multiple share classes in the S&P 500 and other indices. Most US companies, but not all, have only one class of common stock and each share is entitled to one vote.   In some companies with multiple share classes, one class is publicly traded and the other classes are closely held and couldn’t be included in an index. However, there are other companies with multiple classes where more than one class is listed and traded.  Berkshire Hathaway is one of the better known cases; the class A shares traded recently (December 6^th 2013) at about $174,320.00 per share while the class B shares were trading at about $116 per share the same day. The A shares carry one vote, the B shares one-ten-thousandth of a vote; the price ratio is 1500 times.

In the S&P 500 each company is represented by only one share class. Some other indices include multiple share classes of the same company meaning that an investor’s economic exposure to the company can be larger than it appears.  Multiple share classes are often used to permit the founders or the insiders to retain voting control while owning less than 50% of the outstanding stock. In other cases, the lower price class also makes the stock more readily available to investors. Typically one class of a multiple share class name is more liquid than the others and represents a substantial majority of the trading. With Berkshire Hathaway it should be no surprise that most of the trading is in the B class and that the S&P 500 includes the B class. However, Berkshire’s A class represent slightly more than half the value of the company.  So that the S&P 500 reflects the total float adjusted market value of the entire company, the share count of the B class is adjusted to reflect the combined float of both share classes.  This gives a proper picture of the company’s value while maintaining the liquidity of the index.

There is no adjustment for differing voting rights among multiple share classes of a single company.  Such an adjustment is often not even feasible because one class of stock has no voting rights at all or the ratio of the prices of the two classes differs from the ratio of the votes.  In some cases the price differential maybe quite small.  Comcast CMCSA, with one vote, recently traded at about $49.24 while CMCSK with zero votes was $47.61. (Prices on December 6^th 2013).  The extent to which a group of investors could use their votes to force a change in a company’s management or strategy depends on more than just the number of votes per share.  In many companies with a single share class and one vote per share, the management may own more than 50% and be seen as insulated from independent shareholder pressure.  In other cases, where there are multiple classes and one class is “super voting” the company may still prove vulnerable to a take-over.  One example is Dow Jones, acquired by News Corporation a few years ago.

Challenges for index maintenance include choosing the more liquid share and how to handle any shift from one class to another.  Usually the class with the larger number of shares in the public float and with the lower price, if there is a substantial spread, will be more liquid. As mentioned, the choice was easy with Berkshire Hathaway. (Berkshire did not join the S&P 500 until the float in the class B was large enough; adding the class A to the index would have presented problems for indexers.) In some cases, classes have been switched. One example is Comcast where an acquisition for stock resulted in a large increase in CMCSA and it replaced CMCSK in the S&P 500.

Google currently has two classes of stock; class A is in the S&P 500 and carries one vote while class B has ten votes and is closely held.  Google is expected to split both classes by distributing shares in a new class C which will have zero votes per share.  Because each A share and each B share will receive one C share in the split, the new class will be the largest when the split occurs.  Moreover, Google expects any future share issuance for employee compensation, acquisitions or other reasons will be class C shares; the Cs will always be the largest class.  The question for the S&P 500 Index Committee is which class will be in the S&P 500 over the long term and, if need be, how to manage the switch from class A to class C.  These issues are under review, stay tuned for an announcement.

Other posts on Inside the S&P 500  on dividends, on float adjustment and on selecting stocks