Indexology^® Blog

In the article at this link, Bill Luby – VIX analyst extraordinaire – dispels a misconception I have heard repeated at conferences and in presentations. Very often, people refer to VIX as “mean reverting.” This is not correct in the strictest sense of that phrase. VIX is not inclined to return to its long-term average. Rather, VIX is more likely to return to its “typical” levels. It’s more correct to say that VIX is mode reverting. I’ll explain more, since understanding this distinction is essential to understanding VIX. 

In Luby’s words, VIX has an asymmetric return profile. He notes that “VIX spikes are generally short-lived” and that “a low VIX often persists for extended periods.” 

Put another way, VIX is defined by its extremes. It’s like your hothead friend in high school who day to day is a reasonable guy, but occasionally, when something agitates him, he flares up and punches someone. Your friend’s average mood – halfway between calm and ready to commit criminal assault – doesn’t matter that much because he is rarely there. 

Let’s look at the past ten years, ending March 2014, to get a sense as to why an average is a less useful measure in the case of VIX. In that time, we have had 2,517 trading days. The average closing VIX value has been around 20. How many times has VIX closed at or around this average, say between 18 and 22 (those values inclusive)? The answer is 511 times, or 20% of all observations. 

Now let’s look at the most frequently observed level, the mode. After rounding, the VIX level that shows up most is 13. But how often does VIX land at or near this particular level? Again, let’s count. VIX has closed in a range between 11-15 exactly 955 times the past ten years, representing 38% of all trading days.

The best way to see this, however, is with a graph. You see huge upticks, particularly during the financial crisis. But VIX seems to drift back, sooner or later, to a certain base level.

So, the next time you are at a conference and you hear someone say VIX is mean reverting, boldly step up to the mic and correct them. You now know the real story.

The S&P/LSTA U.S. Leveraged Loan 100 Index has returned 1.76% year to date under performing vs. fixed rate high yield bonds.  The low rate environment and continued demand for yield generating asset classes has pushed the S&P U.S. Issued High Yield Corporate Bond Index returns to  4.32% year to date as yields have fallen by 38bps since year end.

Three myths of the U.S. senior loan market:

Myth 1: Senior loans are more volatile than high yield bonds:  the data just does not support this statement.

The five year standard deviation of index level changes (as of quarter end March 31, 2014):

• S&P/LSTA U.S. Leveraged Loan 100 Index:  7.28%
• S&P U.S. Issued High Yield Corporate Bond Index: 8.27%

Biggest index drop:

• S&P/LSTA U.S. Leveraged Loan 100 Index:  -27.9% Dec 2008
• S&P U.S. Issued High Yield Corporate Bond Index: -30.4% Nov 2008

(In Feb 2009, the S&P 500 was down over 46% and the S&P GSCI was down over 67%)

Myth 2: Interest rate floors built into many floating rate loans are a negative attribute of these loans: Senior loans are floating rate.  As rates rise, the interest rates these loans pay eventually rises.  Currently, approximately 80% of the loans in the S&P/LSTA U.S. Leveraged Loan 100 Index have interest rate floors that have protected buyers from the current extremely low rate environment.  As rates rise above those floors, the loans can be expected to pay even higher interest rates.  Meanwhile, lenders are getting higher rates due to these floors than had the floors not been in place. Prices of fixed rate bonds of course fall as bond yields rise.

Myth 3: The liquidity of the loan market is nonexistent:  During the first four months of 2014 over $198billion of senior loans have traded in the secondary market.  The 100 constituents of the S&P/LSTA U.S. Leveraged Loan 100 Index represented 25% of the trade volume (over $50billion). The Index is designed to track the most liquid of these senior loans and results in tracking over $237billion of loans by market value.

Last week India witnessed a historic event at the declaration of its 16th Lok Sabha election results. After a span of over 30 years has there been such a majority mandate handed out by the Indian voters who confirmed their need for change.

Equity Markets
The Indian equity market investors greeted the news favourably with the S&P BSE SENSEX crossing the 25000 mark for the first time in the history of Indian stock markets and further recorded as the third-best performer in Asia in dollar terms. To put it more plainly, the S&P BSE SENSEX has had a return of 15% in just the past 5 ½ months, since the start of this year.

Expectations
Eminent leaders of their field, reputed professionals, and renowned market experts have expressed their recommendation on the areas of reforms. Some of the key expectations are lower Inflation, strengthening of the rupee, improving overall growth rates, lowering of the unemployment rate, revival of the investment scenario and a common wish list among many, a boost to infrastructure.

Government Direction
The Government of India, Planning Commission in its Twelfth Five Year Plan (2012–2017) estimated the total investment in infrastructure sectors to be approximately one trillion dollars. The plan outlines new projects and development in airports with three new airports namely Navi Mumbai, Goa and Kannur. Additionally two ports in West Bengal and Andhra Pradesh. Development in railways to build out the Western and Eastern Freight Corridor, the Mumbai Elevated Rail Corridor and the High Speed Corridor. Roads also form an integral part of the developmental plan along with expansion in power and telecommunication.

Given the gamut of plan, funding of these infrastructure projects is critical. There is an expectation of a contribution of nearly 48% by the private sector. A funding gap is already projected in the plan and this is where the scope for inviting investments in this space broadens to provide the necessary boost.

Value Unlocking
Infrastructure can be the catalyst to provide the necessary boost to many sectors that can cumulatively contribute to economic and overall growth for the country. For those who want to avoid timing the markets or lack stock specific insights, index investing enables exposure to the sector and related returns via a rules based approach provided by an independent index provider.

While the euphoria of the elections is now settling down, May 26, 2014 brings in the swearing in of a new Prime Minister and a new government to realize the hope of a change … a change for a better India…” Acche Din Ayenge”( Good days are here to come)

It’s not just because it took 10 years to negotiate with China or is worth $400 billion, but the new deal Gazprom signed to supply 38 billion cubic meters (bcm), which is about the amount NY state uses annually, of natural gas to China each year for the next 30 years may be a major game changer for 3 big reasons.

The first big reason is that this deal may reduce air pollution in China.  That may not only clean the air for breathing but may reduce the erratic weather causing global warming that is spiking agriculture prices  and now possibly food prices.  Since the deal implicitly prices the natural gas China is receiving from Russia at a 25% to 40% discount to the cost of importing liquefied natural gas from overseas, this may not only cause China to use this gas over the rest of the world’s but it may motivate China to more actively replace oil and coal with natural gas as main energy sources. Given natural gas is cleaner, this in turn may reduce pollution. 

The second reason this deal is a big deal is that it may be the catalyst to building natural gas from a local commodity to a global commodity.  If natural gas becomes more standardized and tradable as a global commodity, it may not only reduce pollution by motivating the switch from oil and coal, but it may include specifications within the contracts to set forth guidelines to control pollution. Currently natural gas is the only commodity in the S&P GSCI where the World Production Quantity is determined based on regional (North American) production.  The globalization largely depends on the logistics and technology in order to transport the gas. For example, in 2013 there was news of a U.K. company signing a deal to bring U.S. natural gas to U.K. homes, which may help the U.S. natural gas globalization, but the trick is having the infrastructure in place to execute the trade.  

Last, this deal may open investment opportunities across the energy spectrum. The construction of the pipeline may initially create some direct investment opportunities but as the pipelines start working, it may possibly further open futures markets, at least regionally if not globally, to encourage more production that may grow the entire market.

The U.S. Department of Commerce released data last Friday showing that housing starts in April were up 26.4% from April of last year and 13.2% since March. In a vacuum, you would expect that the market would look favorably on the homebuilder’s market when the amount of homes being built is increasing.

The home building market however continues to underperform as a sector in 2014. YTD the S&P Homebuilders Select Industry Index (TR) (which benchmarks homebuilding, buildings products, home furnishings, home improvement, retail home furnishings, and household appliances) is down -7.86%. Estranged from overall market benchmarks like the S&P 500(TR), which is up 2.14% on the year. Homebuilder returns are even more dismal when compared to leading sectors such as energy exploration and production, as indicated by the S&P Oil & Gas Exploration & Production Select Industry Index (TR) which is up 8.41% YTD.

 A more telling story is the market’s perception of elevated risk regarding the homebuilder’s market moving forward. Market wide credit default swap spreads for the largest investment grade and high yield issuers have continued to tighten in 2014. This is illustrated by the S&P/ISDA U.S 150 Credit Spread Index which has seen highs of over 91bps in January drop down to 51 bps in 2014. Lower spreads indicate market participants are willing to accept lower risk premiums to “insure” the underlying entities.

Credit default spreads in the housing sector have been widening however, up 21 bps in 2014 to 168 bps. Translated, default insurance on a credit with a notional amount of $100,000 would cost $1,689 or 14% more than it did in January. Energy CDS spreads while trading more closely in price to homebuilders have also fallen in 2014 (S&P/ISDA CDS U.S. Energy Select 10: -7 bps).

The homebuilders’ market sector that was once catalyst to driving the U.S. economy with the wide breathe of industries whom benefitted from its success, is underperforming and viewed as increasingly risky compared to its peers, even in lieu of positive growth.

NOTE: One should be mindful to differentiate the homebuilders market from the overall housing market (which can be tracked using S&P/Case-Shiller National Home Price Index).