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A Comparison of Two Corporate Bond Markets

Corporate Bond Funds: Weighing performance scenarios

Applying a Laddering Strategy to Preferred Portfolios in Canada

Volatility, ya right

Putin Today, Shiller Tomorrow, Yellen on Wednesday

A Comparison of Two Corporate Bond Markets

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Michele Leung

Director, Fixed Income Indices

S&P Dow Jones Indices

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The possibility of interest rates remaining low means investors will continue to search for yield while also looking to diversify market exposures.  Below we offer a snapshot of two corporate bond landscapes: the U.S. corporate bond market and the Chinese corporate bond market, which has expanded rapidly in recent years.

Size
Tracked by the S&P U.S. Issued Investment Grade Corporate Bond Index and the S&P U.S. Issued High Yield Corporate Bond Index, the total size of the U.S. corporate bond market is around USD 4.8 trillion, which is approximately four times that of the Chinese corporate bond market. Within the Chinese corporate bond market, the offshore market, denoted by the S&P/DB ORBIT Credit Index, is relatively small compared with the onshore market, represented by the S&P China Corporate Bond Index.

Duration and Yield
Both onshore and offshore Chinese corporates demonstrated shorter durations and higher yields when compared with U.S. corporates. See Exhibit 1 for the comparison.

  • The S&P U.S. Issued Investment Grade Corporate Bond Index has the longest modified duration and lowest yield-to-maturity when compared with other indices, which reflects the underlying bonds’ quality premium, as well as the difference in the risk-free rates.
  • The S&P China Corporate Bond Index measures the performance of onshore corporate bonds and is composed of locally rated investment-grade, high-yield and unrated bonds. The index generally outperforms the S&P U.S. Issued High Yield Corporate Bond Index in terms of both yield-to-maturity and modified duration. Exhibit 2 lists the top five index constituents, which are all financial entities.
  • Given its short duration and mostly investment-grade-rated composition, the S&P/DB ORBIT Credit Index provides a compelling yield of 4.52%.

Comparison of the Corporate Bond Indices

Top Five Constituents in the SP China Coporate Bond Index

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Corporate Bond Funds: Weighing performance scenarios

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Heather Mcardle

Director, Fixed Income Indices

S&P Dow Jones Indices

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Investors are taught to diversify their portfolio by investing in several different asset classes with different risks and exposures.  In today’s low rate environment, the investment grade corporate bond market in the US and abroad offers a way to pick up additional yield and diversification, while maintaining a relatively low level of risk.  I weighed the performance scenarios of combining both U.S. and International Corporates in today’s economic environment. I compared two corporate bond indices: The S&P International Corporate Bond Index and the S&P US Issued Investment Grade Corporate Bond Index to determine what performance risks both face in their respective markets.  See below a comparison using at 1 year of Yield to Worst (YTW) history.

SP International Corporate Bond vs. SP U.S. Issued Investment Grade Corporate Bond Index YTW 1 Yr History

At first look, we see that the ytw for the US index is 2.85%, while the International index is 2.33%. An investor might choose the US corporate asset class on the lone basis that it is yielding 52bps higher. But to weigh future performance scenarios, while there are many different variables to consider, we will only focus on interest rates and f/x risk, and how those two factors affect bond prices.

The S&P US Issued Investment Grade Corporate Bond Index is comprised of US corporations issuing investment grade bonds in US dollars.  Rates in the US are currently at 0-.25%, all-time lows.  With the tapering of the government stimulus program and positive economic data like the shrinking of the unemployment rate, interest rates in the US are expected to go up.  A rise in interest rates will cause existing bond prices to go down.  This means the 52bp pick up in yield that one gets today would result in a lower total return later, as bond prices would decrease in a rising interest rate environment.

The S&P International Corporate Bond Index is comprised of non-U.S. investment grade corporate issuers and is calculated in US dollars.   Since this index comprises of bonds from the G10 currencies, with the euro having the largest weight, we will focus on Europe.   Europe has low rates of .25% currently. Inflation is very low at .5% and faces deflation risk. The European economy while growing, is growing at a very slow pace, currently .2% and unemployment rates are high. There seems to be no need to raise rates any time soon. If rates don’t go up in Europe then bond prices should remain relatively steady and will hedge any price depreciation in the US.  F/X rates will change the USD value for coupon and redemption payments. If rates in the US go up, the USD will strengthen.  The international fund would be worth less when converted to USD, even though their prices may stay relatively the same, as per the above scenario. Though, there is the possibility that the US economy isn’t growing fast enough for a significant rise in interest rates any time soon. If that’s the case, the USD would not necessarily go up and could weaken, causing the f/x risk in foreign markets to lessen, and possibly raise the value of those bonds in USD.   The USD could also weaken if it loses its safe haven premium.

In today’s market environment it is important to diversify and weigh risks accordingly.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Applying a Laddering Strategy to Preferred Portfolios in Canada

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Phillip Brzenk

Senior Director, Strategy Indices

S&P Dow Jones Indices

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A laddered preferred portfolio uses the same concept as bond laddering, where a portfolio is constructed with instruments of staggering maturities so that a fixed portion of the portfolio matures each year. Rate-reset preferreds are used in a portfolio laddering strategy since they incorporate a reset date every five years. On the reset date, which can also be thought of as a maturity date, either the dividend is adjusted based on a spread above the current five-year government bond yield or the security is called for redemption.

The S&P/TSX Preferred Share Laddered Index is an example of a laddered preferred strategy. The portfolio is broken out into five term buckets based on the reset date calendar year, with each bucket given an equal weighting at rebalancing. This implies that a portion of the portfolio resets each year based on the current interest rate levels. At the beginning of each year, the buckets are changed so that the previously current year term bucket becomes the last term bucket, the year 1 term bucket becomes the current year term bucket, year 2 becomes year 1, and so on.

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Benefits and Risks of a Laddered Preferred Portfolio

The potential benefits of a laddered preferred portfolio largely relate to addressing interest rate risk. Perpetual preferreds have high sensitivity to interest rate changes since they have a fixed dividend payment and no set maturity date. Rate-reset preferreds typically exhibit less interest rate risk as the maximum time to the next reset date, or maturity, is five years. In fact, when looking at duration, it is estimated that rate-reset preferreds have durations between 2 and 3 years whereas perpetual preferreds have durations between 11 and 15 years[1]. In a portfolio context, the laddering strategy helps dampen negative effects of interest rate changes, while still offering the opportunity to participate in increased yields. If interest rates are low in a given year, only a portion of the portfolio will be reset to the lower yields. Conversely, the portfolio can benefit from increased interest rates, as part of the portfolio would reset to higher yields.

Two risks related to rate-reset preferreds involve call risk and changes in the regulatory landscape. Call risk may increase in low interest rate environments; when interest rates are low, credit spreads generally decrease between risk-free assets such as government bonds and risky assets such as preferreds. A company may be able to reduce interest expense by calling an outstanding preferred share class and issuing a new share class at a lower spread above the benchmark yield. Changes to the regulatory landscape also pose a threat to rate-reset preferreds. Under Basel III regulations, most preferreds including rate-resets will no longer be considered part of Tier 1 Capital from 2013 onward. This particularly affects financial institutions, as they are required to hold a certain percentage of total capital in Tier 1 assets. To comply with the new regulations, financial institutions may shift from issuing preferreds to other assets still considered to be Tier 1 Capital.

For more on preferreds in Canada, read our recent paper, “Looking Under the Hood of Canadian Preferred Indices.”

[1] Source: National Bank Financial Product Review: BMO Laddered Preferred Share, Jan. 16, 2013.

The posts on this blog are opinions, not advice. Please read our Disclaimers.

Volatility, ya right

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Howard Silverblatt

Senior Index Analyst, Product Management

S&P Dow Jones Indices

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The market was up 0.7% this morning, and down 0.7% in early afternoon trading, and is currently trending up from the red. So I keep hearing that volatility has returned to the market. Maybe, if you just started trading. Daily volatility, as measured by the daily high price divided by the low price, has increased to an average 0.95% from last year’s 0.85%. However, the prior year, 2012, was 1.07%, with the year before that, 2010 being 1.64%, and the 50-year average is 1.47% – 50% more than the current year. Compared to that data today’s market is tame (the VIX, while up today, is still under 15). The increased perception is due to last year’s low volatility, which was the lowest since 1995. If you truly want to see volatility look at 2008-2009, when it averaged over 2.4% a day, and we saw (many) days where the index was up 1% at 3 p.m. and closed down 1%. pic7Additionally, last year saw significant gains in the market, as 2013 posted a 29.6% gain, with 457 of the S&P 500 issues gaining, as compared to the 2014 year-to-date, which is up 0.81%, with 275 issues up. Also differentiating this year is the number of issues moving well outside the index return of up 0.81% YTD. To date, 103 issues are up at least 10% this year, with 51 declining at least 10%. While the index has been flat, it would appear the battle from within has been ranging, and that has added to the perception of volatility.

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The posts on this blog are opinions, not advice. Please read our Disclaimers.

Putin Today, Shiller Tomorrow, Yellen on Wednesday

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Kevin Horan

Director, Fixed Income Indices

S&P Dow Jones Indices

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Over the course of last week, yields on all on-the-run bonds moved lower.  The yield on the S&P/BGCantor Current 10 Year U.S. Treasury Index closed Friday 11 basis points lower at a 2.67%.  During the week the Treasury did auction $32 billion 2’s, $35 billion 5’s and $29 billion 7-year notes.  Though the 2-year auction was considered weak, flight-to-quality trades and overseas interest helped the 5 and 7 year auctions along.

This morning the focus has been on this week’s Federal Reserve meetings and the Ukraine crisis as the U.S. issued sanctions targeted seven individuals and seventeen Russian companies.  At the same time the European governments have named 15 individuals to the list.  In addition to political news, March U.S. Home Sales month-over-month was stronger than expected reporting 3.4% as only 1% was expected.  In addition to Home Sales, the Dallas Fed Manufacturing Outlook also reported a stronger 11.7 versus the expected 6.0.  The rest of the week is full of potential market moving triggers as the S&P/Case-Shiller Home Price Index along with Mortgage Applications, the ADP Employment Change (210k expected), 1st quarter GDP Price (1.6% exp.) and the FOMC Rate Decision are slated for tomorrow.

The FOMC Rate Decision being the highest priority of the bunch.  Tapering and other main policy targets of the Fed are expected to remain unchanged.  Beyond Wednesday of this week, Initial Jobless Claims (320k exp.), ISM Manufacturing (54.3 exp.), Nonfarm Payrolls (215k exp.) and Unemployment (6.6% exp.) potentially will shed more insight into the degree of strength to the economy.

This week the Treasury will auction $15 billion of a 2-year floating rate note maturing in 2016.  This is a new addition to the already existing $41 billion Jan. 31, 2016 floating rate notes which are returning 0.02% month-to-date as measured by the S&P Current 2-Year U.S. Floating Rate Treasury Index.

On the month and the year, investment grade corporate bonds are outperforming high yield.  The S&P U.S. Issued Investment Grade Corporate Bond Index has returned 1.06% month-to-date and 4.0% year-to-date.  While in comparison the S&P U.S. Issued High Yield Corporate Bond Index has only returned 0.5% and 3.48% respectively.  The OAS (Option Adjusted Spread) of the investment grade corporate rating sub-indices are tighter: AAA (-6 bps), AA (-2 bps), A (-3 bps) and BBB (-5 bps) while high yield’s BB and B are flat and the CCC & below are 22 bps wider.

The S&P/LSTA U.S. Leveraged Loan 100 Index still remains lackluster as the index is down -0.06% month-to-date and is only returning 0.94% year-to-date.  The index’s yield has risen 17 basis points since the beginning of the month and is presently at 5.62%.  The weekly review of this index gives it a floating rate quality.

Source: S&P Dow Jones Indices, Data as of 4/25/2014, Leveraged Loan data as of 4/27/2014.

The posts on this blog are opinions, not advice. Please read our Disclaimers.