Indexology^® Blog

After having risen 19 basis points the first week of July, the yield on the S&P/BGCantor Current 10 Year U.S. Treasury Bond Index dropped 20 basis points from the July 3^rd 2.72% to its current 2.52%, offsetting the initial increase.  The move up in yield to start July was the largest weekly jump since last August (8/16/2013), while last week’s rally moving yields downward was the largest weekly move in yield since a 31 basis point rally back on June 1^st of 2012.  Last week also brought news that the Fed plans to end its tapering activity by October of this year.

Not quite out of the news headlines yet, Puerto Rican municipal bond yields are at 8.13%, right where they began the week, as measured by the S&P Municipal Bond Puerto Rico Index.  Performance of this index year-to-date has returned 0.43% after being as high as 10.65% on May 30^th.  Performance for the month the index is down -5.2%.  The yield of the broader S&P Municipal Bond Index also remained unchanged on the week at a 2.67% though unlike Puerto Rico, the broad index is returning 5.59% year-to-date.

Investment grade bonds as measured by the S&P U.S. Issued Investment Grade Corporate Bond Index turned it up a notch as the index’s yield tightened by 9 basis points on the week to a 2.76%.  Year-to-date this index is now returning more than its high yield counterpart with a year-to-date return of 5.68%.  Last week’s performance added 0.81%, more than enough to offset the prior week’s negative 0.61% that started July.

As mentioned, the S&P U.S. Issued High Yield Corporate Bond Index has returned 5.38% year-to-date.  Last week the index gave up 0.12% for total return after a relatively flat prior week and a string of positive weekly performance since March of this year.  While the yield of the investment grade index moved down by 9 basis points last week, the yield of the high yield index moved the same 9 basis points but upward to a 5.04%.

Continuing to yield 4.34%, the S&P/LSTA U.S. Leveraged Loan 100 Index has returned +0.08% month-to-date while the similar credit of high yield was down -0.15%.  Year-to-date the senior loan index has returned 2.56%.

The S&P U.S. Preferred Stock Index’stotal return is up 0.55% on the month while equities as measured by the S&P 500®are returning a very close 0.45%.  Year-to-date total return performance is not even close as preferreds are outperforming the equity markets returning a total return of 11.64% compared to the equity markets total return of 7.62%

There are no Monday economic releases for this week, but the rest of the calendar should pack a punch.  As the strength of the recovery is still in question, Tuesday’s release of the Empire Manufacturing Survey (17 expected, 19.28 prior) along with the June month-over-month Advance Retail Sales (0.6%exp., 0.3% prior) should shed some insight to the debate.  The June Import Price Index (0.4% exp) is also set to be released for Tuesday.  MBA Mortgage Applications (1.9% prior) along with June’s PPI (Producer Price Index (0.2% exp., -0.2% prior) and Industrial Production (0.3% exp., 0.6% prior) will make for a busy Wednesday.  After the “hump-day”, Housing Starts (1020k exp.), Initial Jobless Claims (310k exp., 304k prior) and the Philadelphia Fed Business Outlook (16 vs. 17.8 prior) will follow.  The week will close with the release of both the University of Michigan Confidence number (83 exp. vs. 82.5 prior) and the Conference Board of U.S. Leading Index which is expected to be unchanged from its prior release at a 0.5%.  The Leading Index gives an indication of the future state of the economy.

Source: S&P Dow Jones Indices, Data as of 7/11/2014, Leveraged Loan data as of 7/13/2014.

Fed Chair Janet Yellen testifies on Tuesday and Wednesday this week to House and Senate Committees as part of the Fed’s mid-year report on monetary policy.  Last week’s release of the FOMC minutes from the June 17-18 meeting set the stage for this week’s testimony and questions.   The big question — when will the Fed begin raising interest rates – won’t get an answer from Mrs. Yellen.  The consensus guess is mid-2015; since the release of the minutes and the May employment report many analysts have moved their dates closer to now.

Other questions were answered and will probably be debated.  While the current round of quantitative easing and bond buying will end in October, the Fed will continue to reinvest funds from coupon interest and maturing bonds until sometime after they begin raising interest rates.  Yes, the Fed noted the recent uptick in some inflation measures which occasioned a lot of discussion among bloggers, and no, it is not worried about inflation and won’t respond with higher interest rates out of fears of inflation.

After some ups and down last week, the stock market will be listening with care.  Given the FOMC minutes and the recent tone of Fed comments, the testimony shouldn’t send stocks into a tailspin.  Comments on the economy will be neutral at best and won’t encourage any buying or upward revisions of earnings estimates.  Old-line monetarists who worry a lot about inflation may be even more worried given Janet Yellen’s earlier comments on inflation.   The wild card in the Q&A sessions in both the House and the Senate could be comments by a minority who want to hobble the Fed by forcing it to follow arbitrary policy rules or build a wall between interest rate policy and all bank regulation.  Some in Congress are jealous of the Fed’s policy-making power or don’t wish to recognize the crucial and successful role it played during the financial crisis. Remarks about the Fed’s structure will only heighten uncertainty about future monetary policy.

Most of the questions from representatives and senators are likely to focus on the economy and recovery, but a few may get wonkish and discuss how, not when, the Fed will raise interest rates.  One of the long running complaints about quantitative easing is that it flooded the banking system with excess reserves. Initially some feared that all that money would create inflation; it hasn’t. Now the question will be how to raise interest rates when it is impossible to drain enough excess reserves to create upward pressure on the fed funds rate.  The FOMC minutes covered this issue., The Fed will continue to pay interest on excess reserves (IOER) and this rate will be a key policy tool going forward, Second, the Fed will establish an overnight reverse repurchase facility to supplement the IOER and drain reserves for brief time periods.

The FOMC did note one challenge it will face, both with Congress and the markets.  With new policy tools, it will need to explain and educate both sets of constituents about what it is doing and how things will work.  This week’s testimony may be an early signal of this education effort.

Stay tuned this week for the testimony and what it all means.

As the Chinese bond market rapidly expands, reaching almost CNY 30 trillion, it has gained an increasing amount of attention from global investors.  Tracked by the S&P China Bond Index, the total return of the CNY-denominated bonds rose 5.7% in the 1H of 2014.

While the risk of default put downward pressure to the Chinese corporates in the beginning of year, the sentiment improved as the government strives to roll out financial reforms and promote growth. The S&P China Corporate Bond Index managed to retreat from the lows and delivered a total return of 5.98%, which outperformed the S&P China Government Bond Index in the same period. Please see Exhibit 1 below.

While both Chinese government and corporate bonds traded tighter, the yield of the S&P China Corporate Bond Index tightened by 91bps to 5.56%, as of June 30, 2014. Notably, the yields of the sector level indices – S&P China Services Bond Index and S&P China Utilities Bond Index tightened by 1.08% and 1.14% respectively.

The Chinese government continues to support the economy while carrying out financial and capital market reforms.  For example, the China Banking Regulatory Commission (CBRC) recently announced changes in the calculation of the Loan to Deposit Ratio (LDR). The ratio is adjusted by exempting certain loans (i.e. backed by financial bonds) and including Negotiable Certificate of Deposits (NCDs) and certain offshore deposits.

Separately, the regulatory support for offshore RMB business also accelerated, three offshore RMB clearing banks were established in London, Frankfurt and Seoul, while Paris and Luxembourg are the next potential candidates.

Exhibit 1: Total Return Performance of the S&P China Bond Index 

Source: S&P Dow Jones Indices.  Data as of June 30, 2014.  Charts are provided for illustrative purposes.  Past performance is not a guarantee of future results.

“Weighing In:” will be a series of posts comparing and contrasting the impact of different weighting schemes within commodity indices. The series will be the first to feature our two headline indices, the equally weighted Dow Jones Commodity Index (DJCI) and the world production weighted S&P GSCI.  The purpose of the series is to help you reach your portfolio goals by understanding the effect of weighting inside commodity indices. We will kick off with a description of the difference between the two major weighting schemes, and in subsequent discussions will analyze the historical behaviors of each of the indices.

Both the DJCI and S&P GSCI have the same methodologies with the exception of the weighting schemes and the rebalance periods back to their respective target weights. The resulting index compositions differ dramatically. See below for a comparative snapshot of weights as of July 9, 2014:

Notice the significant difference in the weights, especially in energy where the DJCI has 33.8% and the S&P GSCI has an energy weight of 72.1%. Also notice the relatively low weight in the S&P GSCI of metals at 9.6% versus 35.5% in the DJCI, and lower agriculture and livestock weight 18.2% in the S&P GSCI versus 30.7% weight in the DJCI.

Why is this?

Again, It is from the different weighting methods between the indices. The DJCI is an equally weighted index where step one is to liquidity weight each commodity by a 5 year average of total dollar value traded. Next the commodities are grouped into components by their physical similarities and correlations to apply caps to further diversify. The caps are applied so that no more than one component is greater than 32% and no subsequent component is greater than 17%. This is done in an interative process until the requirement is filled. Last the sectors are limited to 33% each and this is rebalanced quarterly.  The goal is to incorporate diversification and liquidity as the intrinsic characteristics of the index.

The S&P GSCI is a world production weighted index where the goal is to reflect the relative significance of each of the constituent commodities to the world economy, while preserving the tradability of the index by limiting eligible contracts to those with adequate liquidity.

With respect to each Designated Contract, a Contract Production Weight (CPW) is calculated based on world production and trading volume. The final CPWs are rounded to seven digits of precision.

The calculation of the CPWs of the Designated Contracts involves a four-step process: (1) determination of the World Production Quantity (WPQ) of each S&P GSCI Commodity, (2) determination of the World Production Average (WPA) of each S&P GSCI Commodity over the WPQ Period, (3) calculation of the CPW based on the Contract’s percentage of the relevant Total Quantity Traded (TQT), and (4) certain adjustments to the CPWs.

World Production Quantity (WPQ)

The WPQ of each S&P GSCI Commodity is equal to the total world production of the S&P GSCI Commodity over the WPQ Period.

The use of the five-year WPQ Period (and the averaging of that five-year period to determine the WPAs) is intended to mitigate the effect of any aberrational years with respect to the production of a particular commodity.  For example, if a given commodity is produced primarily in one part of the world that suffers damage from hurricanes or earthquakes in a particular year, resulting in curtailed production levels, the use of that year’s production figures might not accurately reflect the significance of the commodity to the world economy.  Commodity production in a particular year may also be higher or lower than would normally be the case as a result of general production cycles, supply and demand cycles, or worldwide economic conditions.  Measuring production levels over a five-year period should generally smooth out any such aberrational years.

The definition of the WPQ Period imposes a delay of approximately one-and-one-half (1 ½) years between the end of the WPQ Period and the end of the relevant Annual Calculation Period.  This delay is because world production statistics are often incomplete and subject to revision after their original publication.  Imposing a delay on the WPQ Period generally enhances their accuracy and reliability.

The WPQ Period is defined as the most recent five-year period for which complete world production data is available for all S&P GSCI Commodities from sources determined by S&P Indices to be reasonably accurate and reliable. This procedure is intended to assure that the same WPQ Period is used for all S&P GSCI Commodities, which allows comparisons between production figures to be made without taking into account temporary aberrations in different time periods.

World Production Average (WPA)

The WPA is simply the average annual production amount of the S&P GSCI Commodity based on the WPQ over a five-year period.

Contract Production Weight (CPW)

In calculating the CPW of each Designated Contract on a particular S&P GSCI Commodity, the WPA of such Commodity is allocated to those Designated Contracts that can best support liquidity. 

With respect to each Designated Contract, the CPW is equal to the Percentage TQT for such Contract multiplied by the WPA of the underlying S&P GSCI Commodity (after any necessary conversion made for purposes of the calculation) and divided by 1,000,000.

The simpler of the two is the equally weighted DJCI. However, both indices are used as asset class representations in order to fulfill different portfolio goals.  The most popular reasons investors use commodity indices are for diversification and inflation protection, so we will evaluate the historical effectiveness of both indices in these roles. Additionally, we may explore how well each of the indices fills requirements of other motivations behind commodity allocations such as liquidity, emerging markets exposure, or hedging against rising interest rates.

Today’s New York Times headlined an article, “The Everything Boom: How it Might End” (here) pointing out that prices in almost every asset class have reached stratospheric levels driven by low interest rates and easy money.  The article suggests three ways the boom might end: The good where the economy grows into currently high asset values and interest rates slowly rise; the bad where the economy stagnates and investment returns fade towards zero; or, the ugly where inflation or some crisis leads to collapse.  It missed a fourth – today’s irrational exuberance evaporates when people realize how far prices are from any fundamental values.

Rather than argue about the future, is there anything investors who fear the end can do now? Consider cash.  Shifting part of an investment to cash from stocks, bonds or commodities reduces its volatility and shrinks the size of the maximum drawdown while trimming prospective returns. Cash earns zero return with zero volatility.  The attractive part is the zero volatility.   Inflation is a risk to cash since rising prices makes the cash worth less. However, it is a slow moving risk compared with falling stock and bond prices: 10% annual inflation is quite high, hasn’t been seen in the US since the early 1980s and would take time to become part of the economy; a 10% drop in stocks or bonds can happen in a matter of days or weeks.

The chart shows a strategy of 60% tracking the S&P 500 and 40% tracking cash compared to 100% tracking the S&P 500.  The figures are quarterly beginning with the first quarter of 2000 and rebalancing to 60/40 each quarter.  Dividends, taxes and expenses are not included.  Starting close to the peak of the Tech boom and continuing through the second quarter of 2014, the 60% stocks-40% cash strategy out-performs the 100% in stocks approach until the end of the third quarter last year.  At the end of June, 2014 the all stocks is ahead by 6%.  Over the 13-1/2 years, the volatility of the 60/40 strategy is 10.4% compared to 17.4% for the S&P 500. Likewise, the maximum draw down for the 60/40 is 14% compared to 23% for the 100% in the S&P 500.

Cash is not always the answer though.  Had one started the same comparison with the fourth quarter of 2002 – the end of the Tech bust – the results would have been different. The 100% in stocks choice would have out-performed the 60/40 strategy except for a few quarters and ended with a spread of about 25%. The volatilities differ only slightly due to a different time period and the maximum draw downs (which occurred during the financial crisis) are the same.  While the moment to switch some holdings to cash is the peak of a market cycle, no one knows the peak until long after it happens.

A final thought to how the Everything Bubble might end is that under each of the scenarios mentioned above investment returns will fall.