Indexology^® Blog

In terms of fixed-income investing, 2013 is a year for the history books. Consequently, the question of what will 2014 bring for the fixed income investor arises. Some significant understanding of future fixed-income investing can be inferred from the recent past. The equity market had a very successful 2013 as the S&P 500 Index returned 29.6% for the year. Year-to-date, the stock market is down 0.38%, though we’ve only had a few trading days so far in 2014. For fixed income investments, yields have been on the rise going into the New Year and there are questions of the declining benefits of Fed stimulus, the timing of the tapering, and improving economics measured by jobs, manufacturing, and housing. This begs to question how much volatility equity and fixed income investments may experience.

In order to get a comparison between the two asset classes, the chart below looks at the daily total return of the S&P 500 Index and S&P Dow Jone’s fixed income indices over the past five years. The yearly standard deviation or volatility of daily returns for the S&P 500 has declined since the 2008 financial crisis, though with a 2013 volatility of 0.69, it is still higher than any of the fixed income indices. Treasury and senior bank loans, as measured by the S&P/BGCantor US Treasury Bond Index and the S&P/LSTA U.S. Leveraged Loan 100 Index, were the two fixed income indices whose volatility declined in 2013 to -0.147 and 0.056 respectively. The yields of indices may have started last year and ended this year rather close to each other with U.S. Treasuries, U.S. agencies, and investment grade corporates 30 to 50 basis points wider than they were at the start of the year. U.S. high yield and senior loans were tighter by 18 and 64 basis points, respectively. Given all the press that municipal bonds had received regarding Puerto Rico and Detroit throughout the year, it comes as no surprise that the S&P National AMT-Free Municipal Bond Index ended the year 100 basis points wider than it did at the start of the year when it was at a 3.06%. The S&P National AMT-Free Municipal Bond Index’s volatility rose 0.08 in 2013 to 0.206 from 2012’s level of 0.126. The S&P U.S. Issued Investment Grade Corporate Bond Index was not far behind municipals with an increase of 0.05, while the S&P U.S. Issued High Yield Corporate Bond Index’s volatility rose by 0.03 to 0.181.

Credit stories will continue to be an important factor in 2014 along with the changes in rates. With lower volatility to equity and a more predictability of returns, investors should take the volatility of the differing fixed income products compared with equity into consideration as they invest with the differing asset classes.

Yesterday’s release of the December 17-18 2013 FOMC minutes by the Fed revealed concerns about the side effects of the quantitative easing.  While these don’t suggest an accelerated end to the Fed’s bond buying – the popular guess is still that it winds down by year end – members of the Fed’s key policy-making group do have some concerns.

First is the thought that the current rock bottom interest rates may encourage financial risk taking and bubbles.  This has been widely discussed outside the Fed so its mention is not much of a surprise. In fact, one of the goals of QE 1-2-3 was to encourage more risk-taking to boost asset prices and begin restoring wealth that vanished in the financial crisis. However, the FOMC discussion adds an interesting observation: the asset buying, unlike targeting the Fed funds rate, not only keeps short term rates close to the zero lower bound, it also affects the spreads among different maturities.  While the Fed has long experience with managing the Fed funds rate, the only previous sustained effort to shift the spreads between different maturities of treasuries was back in the 1960s in a very different market.  Some FOMC members are apparently worried that there might be unexpected or unwanted results as the spreads narrow.

While QE does affect the spreads, the Fed’s forward guidance – forecasting what it expects to do – has a larger effect on spreads between treasury maturities than QE.  Once the central bank announces that short term rates will be very low for another two years, the spread between one and two years treasuries will shrink to those very low short term rates.  Either way, altering the differences among short, intermediate and long term treasury bonds is a new and novel policy tool for the Fed.

The discussion of QE also mentions impacts on the Fed’s profit position.  “Profit” should be in quotes.  When the Fed earns a profit, the proceeds go directly to the treasury. Moreover, since its principle source of income is interest on US treasury securities, the central bank is, in effect, reimbursing the Treasury.  The concern is more likely about appearances than actual profits and losses. Currently the Fed is holding a lot of treasury and mortgage securities; when interest rates rise the prices of these bonds will drop and the Fed will book a capital loss.  In addition, the Fed pays interest on the reserves banks keep at the Fed.  How would things look if the Fed were paying banks interest while it was losing money?  The small, dedicated and vocal group that wants to do away with the Fed might seize on such an event and create havoc in the financial markets.

No rush to end quantitative easing is likely. Even with these concerns, the FOMC expects to reduce the pace of QE gradually over future meetings. In fact the only dissenting vote argued that the Fed should wait awhile longer before cutting back on quantitative easing.

The universal complaint heard today is the “Arctic Vortex” and freezing temperatures across much of the US including financial centers in New York, Chicago and Boston. Are the cold and the weather just something to complain about or do they really affect people and the stock market?  There are various academic studies about how the weather might affect the market covering the US using New York City weather data, Australia and even Thailand.  The results for cold and stock prices are mixed: some find some weak connection between daily temperatures and stock price movements, some find no result at all.  However, a number of studies find a connection between sunshine or clouds and stock prices – if the morning is sunny, the market is more likely to advance.  While one day is clearly an insufficient sample, the sun is out in New York (despite the five degree temperature) and the market is up.  Clouds, overcast and rain seem to be associated with mixed to poor markets, probably another case of psychology and (ir)rationality driving stocks.

Cold does make one large, unfortunate difference: extreme cold, or hot, weather increases mortality rates. Cold is far more damaging than hot weather, so much so that one study found that people migrating to the southern states in the US is contributing to increasing life expectancy in the statistics.

“A rose by any other name would smell as sweet” Juliet says to Romeo when trying to illustrate it is the essence of a something which is important, not what it’s called.  If Shakespeare were alive today, and Juliet were an investor, would he have her say the same things about an ETF?  Would she tell her beloved Romeo that an ETF by any other acronym would still invest in an index and be transparent?  Should 2014 turn out to be the year of the actively managed “ETF”, the answer is probably no because the essence of what had defined ETFs may completely change.

If it is the essence or function of something that matters, like the sweetness of a rose, then the acronym “ETF” could become misleading.   A simple google search of “ETF” in 2013 yields Wikipedia as the very 1st link. In the first paragraph on ETFs Wikipedia states “Most ETFs track an index, such as a stock index or bond index. ETFs may be attractive as investments because of their low costs, tax efficiency, and stock-like features”.[1]  In the 2^nd link, Investopedia defines an ETF as a “A security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange.”[2]

Thus the average investor would probably conclude the function (or essence) of an ETF is to track an index, therefore you know what you are purchasing.  It’s fair to assume they might also deduce that ETFs are good alternatives to many mutual funds because ETFs are said to be “cheap” and “transparent”.  Since their inception till 2013 ETFs have been synonymous with passive investing, just as roses have always been deemed to smell sweet.  This has arguably been a key driver to the success and growth of ETF industry and a boon to investors.

In 2014 we may see the beginning of an unraveling in the commonly assumed (and generally accurate) definition of ETFs because “actively managed ETFs that would be permitted to report their portfolio holdings quarterly” [3] may become typical for many new “ETF” launches. “That would put their reporting requirements on par with traditional mutual funds.”[4]  Thus if one uses the acronym “ETF” to describe both active and passively managed strategies a contradiction ensues, unless of course Wikipedia, Investopedia and countless others totally change their understanding of an ETFs essence.

2013 is the first year commodities have been in backwardation since 2003.  For those of you who need a refresher on the definition of backwardation, you are not alone, so here it is: “When a near-month futures contract is trading at a premium to more distant contracts, we say that a commodity futures curve is in “backwardation” or that the commodity is “backwardated.” This occurs when inventories of commodities are tight so market participants are willing to pay a premium to buy the immediate deliverable commodity. Theoretically there is no value to carrying costs such as storage, insurance and interest costs since there is a scarcity of the commodities.”

Also, for illustrative purposes, this graph may help:

The measurement of the historical backwardation (and contango, which is the converse of backwardation) shown in the chart below calculates the annual roll yield by taking the annual return of the S&P GSCI Excess Return (which measures the price return plus the roll return) less the annual returns of the S&P GSCI Spot Return (which measures the price return only). Backwardation was implied by a positive result, whereas contango was implied by a negative result. Notice 2013 had the first positive result since 2003.

The implication of this, as mentioned in a paper titled “Identifying Return Opportunities In A Demand-Driven World Economy” published by Marya Alsati-Morad, Peter Tsui and me, is that when commodities are backwardated, indices like the S&P GSCI and DJ-UBS that hold the near-month commodity futures contracts may earn a positive return from rolling into a cheaper contract before expiry.

For extra valuable insight on the impacts of contango and backwardation, please watch this special interview with Bob Greer, Executive Vice President & Manager of Real Return Products, PIMCO and Boris Shrayer, (former) Managing Director & Global Head of Commodities Marketing, Morgan Stanley.

For more on the environment and the index development and rolling versus weighting please see the links aforementioned.

Last but not least, something that is particularly interesting is that the last long streak of backwardation happened in 1984-1991, following a precipitous drop in gold of 48% from 1980-84.  During this the time of backwardation, the S&P GSCI returned positive every year between 1984-1990 for a total of 221%.