Indexology^® Blog

As with each summer’s fashion a new color of dress becomes the “new black”.  Pink, green, orange, you make the choice.  In regard to the bond markets the question could be is 3% the new black?  Bill Gross seems to think so, he is calling for economic growth and yields to remain slow and low, not returning to the levels seen prior to 2008.  Global central banking monetary policy has been highly accommodative.  Actions last week seem to support Mr. Gross’s view as the European Central bank followed through with a much expected cut in rates moving the benchmark rate from 0.25% to 0.15% and the Deposit facility from 0% to -0.10%.

Last week provided plenty of information and enough commentary to heat the debate of the direction of interest rates.  The reaction to German unemployment, unwinding of shorts and the expectations for an ECB rate cut that brought the US 10-year down to a 2.40% just prior to month end eased as rates have crept back upwards.  The yield of the S&P/BGCantor Current 10 Year U.S. Treasury Index started the week at a 2.53% and continued upward to a 2.60%.  Currently 2.6% is 40 basis points below the beginning of the year’s 3%.

The U.S. economic calendar for this week starts tomorrow with Wholesale Inventories for April expected at a 0.5% versus the prior 1.1%.  Wednesday’s MBA Mortgage Applications (-3.1% prior) and Thursday’s Retail Sales (0.6% expected), Initial Jobless Claims (310k exp.) and Business Inventories (0.4% exp.) will all be announced.  Friday will close the week with May’s PPI (0.1% exp.) and the University of Michigan Confidence from which an 83 is expected, up from the prior 91.9.

The search for yield has put a spotlight on the higher yielding credits like senior loans and high yield bonds but what about investment grade credits?  The demand for corporate bonds has been very high and corporate issuers have met demand as mentioned in Tim Sturrock’s article Global Fixed Income Investors Flock to Corporate Bonds.  According to Tim, “corporate bonds in particular, are drawing the bulk of new assets, while government bond strategies are bleeding assets.” The S&P U.S. Issued Investment Grade Corporate Bond Index has returned 4.75% year to date.

After lagging the year-to-date total return of investment grade corporates, the S&P U.S. Issued High Yield Corporate Bond Index surpassed its investment grade counterpart by closing the week with a return of 4.89% YTD.  New Issuance by names such as Advanced Micro Devices, Cascades Inc., DFC Finance, Outerwall, Polymer Group and TRI Pionte Homes having fed the demand for high yield paper.

The S&P/LSTA U.S. Leveraged Loan 100 Index returned 0.16% month-to-date and now has returned 2.08% for the year.  Issuance totals mounted quickly this week as borrowers eyed climbing rates ahead of potentially abetting inputs from ECB policy. A total of 23 issuers placed roughly $26 billion of new supply from Monday to Wednesday, with slower conditions expected late in the week.

The S&P U.S. Preferred Stock Index (TR) was down for the week and the start of the month returning -0.65%.  The year-to-date high of 9.86% reached on May 19^th has shrunk to 9.68% while strength in the equity markets may have seen investor reallocating funds as the year-to-date return of the S&P 500 has gone from 2.8% to 6.43% over the same time frame.

Source: S&P Dow Jones Indices, Data as of 6/6/2014, Leveraged Loan data as of 6/8/2014.

Leveraged loans or Senior Loans once an obscure area in Fixed Income space has seen real growth in assets inflow in last couple of years. Lipper reported a 95 week of net inflows in loan funds that ended in April of this year. What are senior loans and what makes them so attractive in this market.

Senior secured loans: Leveraged Loans or senior loans are on top of a company’s capital structure so they are the first to be repaid before other debt obligations and equity holders.

Higher yields: Most of the debt issued under this category is below investment-grade, thus the securities have higher than comparable investment grade instruments.

Floating rate: Coupon is floating rate, generally pegged to 3 month LIBOR resetting quarterly or on a preset frequency with 0.25 duration, thus the interest rate risk is minimum.

Diversification: Since the instruments are floating rate and get reset as the interest rates rise, it provides a good diversification for a traditional fixed income portfolio.

Recognizing the importance of this asset class, S&P Dow Jones Indices developed the S&P Indices Versus Active (SPIVA) Scorecard dedicated to Senior Loans. SPIVA Scorecard measures the performance of actively managed floating-rate loan funds vs. their benchmark, the S&P/LSTA U.S. Leveraged Loan 100 Index. Here are some of the stats:

• Active funds fared well over the 12-month period ending Dec. 31, 2013, with the majority of active funds (60%) outperforming the benchmark.
• However, when viewed over medium- to long-term, three- and five-year horizons, 61.54% and 90.48% of the active loan participation funds underperformed the benchmark, respectively.
• Over the past five years, the number of loan participation funds has nearly doubled, from 21 to 40, which is a testament to the growing popularity of the asset class.

This post looks at why index earnings are derived by summing earnings of index constituents without first weighting the earnings by index weight (cap-weight or otherwise). While earnings are probably the most widely followed fundamental item, this explanation is applicable to a data point of one’s choice – operating earnings, cash flow, etc. An easy way to understand this kind of fundamental index data is to think of an index, such as the S&P 500, as a hypothetical portfolio.

Consider a theoretical example in which we hold 1,000 shares in each of two stocks, ABC and XYZ. ABC is quite profitable, while XYZ is operating at a loss.

Despite the fact that 95% of the portfolio is invested in a stock with a PE of 13.3 ($40/$3), the portfolio as a whole has a claim to $1,600 in total earnings. We can’t ignore the losses generated by XYZ simply because we wish to – we hold 1,000 shares and each one is losing $1.40.

Dividing portfolio value by portfolio earnings claims gives a ratio of 26.25 – the price to earnings ratio (PE) of the portfolio. PE, calculated on this basis, has the useful property of indicating how long it takes to “earn” back our investment under current conditions – in this case, 26 ¼ years.

Conversely, if we were to weigh earnings claims by portfolio weights we would get the following:

It’s clear to see that one could easily be lead astray by the $2,790 earnings figure, which is the sum of weighted earnings claims. The most significant observation is that the portfolio does not, in fact, hold claim on $2,790 in earnings. This figure exaggerates our legitimate claim of $1,600 by $1,190! Obviously, if one were to calculate a PE ratio on this basis, it would be unrealistically low. Our two-stock example shows that a cumulative dollar, whether earned or lost, is equivalent in the aggregate of a portfolio whether it is derived from a large holding or a small one.

Similarly, index earnings represent the aggregate earnings of all companies in the index, and on this basis the index PE provides valuable information. A high index PE may imply a small, or nonexistent, margin of safety – the central investment concept articulated by Ben Graham, who described it as “the secret of sound investment…” and “always dependent on the price paid…”[1]

For more on the ins and outs of index earnings, see David Blitzer’s post from earlier in the year.

[1] Benjamin Graham, The Intelligent Investor, Revised Ed, pages 512, 517. (New York: HarperCollins, 2003)

Many political analysts wrote about coalition politics in India with a deep rooted perception that it is here to stay forever. A stable central government with a single party majority is now a reality!! This has rightly been referred to as the beginning of a new era for India with a significant shift from complicated coalition politics.

During the first few days of living in this new era, I have been interacting with students, business community, CXOs of different industries, young professionals in early years of career and retired elders in the society – the common point of discussion was the election outcome, moving on then to different areas of expectations from the new government under the dynamic leadership of Mr. Narendra Modi.

The excitement, euphoria and now expectations can be seen and felt everywhere. There will be no magic wand which can make changes overnight.

One of the tailwinds for the new government would be India’s current demographic profile and its potential to supplement our transition as a global economic leader. However with increased longevity, the large young workforce of today will live longer and need much more support in the future which could pose some severe socio-economic challenges in the years ahead. India currently does not have a universal social security system similar to some of the developed nations and hence it is important to have a personal long term plan to ensure old-age financial security in the future.

Pension schemes which are structured keeping in mind the retail individual and one of the lowest cost pension products in the world.It starts with a one-time process followed by regular investments with the option of taking a part of the corpus as lump sum amount and the balance in form of monthly income at retirement. It is often said that “Financial Planning in India = Tax Planning” . Some specific pension schemes meet this criteria by offering a special tax deduction for salaried employees over and above the usual deduction for investments of Rs. 100,000, for an amount up to 10% of Basic Salary without any monetary cap.

Monthly contributions ensure discipline of systematic investing. With the auto-choice option, allocation can be made amongst equity, corporate bonds and government bonds dynamically based on age profile.

Whether it is personal financial planning or strategic navigation of the government, the key is to have a steady focus on achieving long term goals. Making this point about long term focus, Mr. Modi said in his first speech at BJP’s Parliamentary Party meeting after elections that “…when we meet in 2019, I will give you and my countrymen a report card…”. A long term focus may, perhaps, augur well for many when it comes to taking stock of their future financial security.

China has recently announced some potential changes in its municipal bond market, which will allow the local governments to sell bond on their own credits, as opposed to the majority of local government bonds that are currently issued by the Ministry of Finance. The coverage is targeted to expand to Beijing, Jiangxi, Ningxie and Qingdao, in addition to the six local governments that were approved in last three years. As highlighted by the author in the article, China Needs Municipal Bond Rethink, raising transparency is definitely the objective to this disclosure-based system. The author also expected more participation from the retail investors in the municipal bond market following the change.

This suggested development in the municipal bond market is perceived as a positive sign, which encourages further growth in the China onshore bond market. It would also help the local governments to meet the financing needs while also to strengthen their debt profile. Echoing an important point raised by the NPC Law Committee member, the local governments’ debt raising should be further regulated so that the process can become more legalized and transparent.

The S&P China Provincial Bond Index measures the performance of the China provincial and municipal bonds; its total return rose 6.84% since is first value date of Nov 20, 2011. The market value tracked by the index is around CNY 118 billion, which is relatively small if you compare with the total China government bond market size of  CNY 15.5 trillion, as tracked by the S&P China Government Bond Index. Noted from the historical yield performance in the chart below, the S&P China Provincial Bond Index traded tighter than S&P China Sovereign Bond Index prior to August 2012, which may implied the yields were artificially compressed as to minimize the financing cost for the municipals. Since then, the S&P China Provincial Bond Index has been trading at an average spread of 25bps wider than the S&P China Sovereign Bond Index.

 Historical Yield Performance (%)

Source: S&P Dow Jones Indices. Data as of Jun 6, 2014. Charts are provided for illustrative purposes. This chart may reflect hypothetical historical performance. Please see the Performance Disclosures at the end of this document for more information regarding the inherent limitations associated with back-tested performance. Past performance is no guarantee of future results