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Mid-July Muni Minutes

Treasury Curve Flattening Helps Long Duration; Investment Grade Bonds Continue to Perform

S&P 500 Pensions and OPEB: good for companies, not good for our retirement

Climate Change May Destroy The Risk Premium

Weighing In: On Inflation

Mid-July Muni Minutes

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Tyler Cling

Senior Manager, Fixed Income Indices

S&P Dow Jones Indices

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Detroit: The anniversary of the city of Detroit essentially declaring bankruptcy by cancelling payments on $40 million of debt obligations last summer is not dragging down the state of Michigan. As observed by the S&P Municipal Bond Michigan General Obligation Index, the state’s debt is trading on par with the rest of the U.S. municipal bond universe.   Both Michigan G.O. bonds and the S&P Municipal Bond Index have annual returns between 6-7% with yields struggling to eclipse 3%. The federal ruling last week that entitles Detroit to $15 million a month in casino revenue certainly helps the city’s ability to make their debt payments.

Puerto Rico: Puerto Rico had investors demanding higher yields last week after the island passed a law in late June allowing PREPA, the Puerto Rico Electric Power Authority, to restructure their debt. The edict was not received warmly by the holders of $73 billion dollars in Puerto Rico related debt, especially since the unincorporated territory doesn’t have the benefit of bankruptcy Chapter 9. Investors are demanding higher yields to hold the recent downgrade to junk status debt. This is demonstrated in the graph below with the S&P Municipal Bond Puerto Rico Index. Yields have risen from 7.35% to 7.95% or 60bps since the beginning of the month. The index has a negative 1-year return of (15.58%).

SP Municipal Bond Puerto Rico Index

Tobacco: July hasn’t been good to tobacco bond holders either. Following the Tobacco Master Settlement Agreement of 1998, tobacco companies have to essentially pay a sin tax for the negative effect their product has on American health. Percentages of revenue from the likes of Philip Morris & R.J. Reynolds have been ruled to contribute towards smoking related medical costs and awareness campaigns. The agreement, which has a minimum cash flow floor of $206 billion over the 25-year span since the enactment, is being used as the source of funds on the municipal tobacco debt.

Tobacco debt as an asset class has been a rockstar so far into 2014, the S&P Municipal Bond Tobacco Index has returned 10.31%YTD. The party could be over, however, as the weighted average price of bonds in the index has dropped (7.6%) in July as seen below. The picture is not all doom and gloom for tobacco debt as the total return of the index is only down (1.4%) for the month. Remember that the revenue used to repay this debt only comes from American tobacco use, so an increase in trends like SE Asia smoking habits or U.S. E-cigarettes does not generate extra cash flow for the tobacco settlement bonds.

SP Municipal Bond Tobacco Index

For a broader insight into the world of fixed income and a look into the upcoming events signaling the pace of our economic recovery, please refer to a recent post by my colleague, Kevin Horan.

 

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

Treasury Curve Flattening Helps Long Duration; Investment Grade Bonds Continue to Perform

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Kevin Horan

Director, Fixed Income Indices

S&P Dow Jones Indices

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Last week’s performance saw the overall Treasury market as measured by the S&P/BGCantor US Treasury Bond Index return 0.03% and is now at 2.08% for the year.  Yields moved lower as the yield-to-worst of the S&P/BGCantor Current 10 Year U.S. Treasury Bond Index is now at a 2.49% which brings it back down to level seen at the end of May.  The spread between 2s – 30s using the yield-to-worst of the S&P/BGCantor Current 30 Year U.S. Treasury Bond Index and the S&P/BGCantor Current 2 Year U.S. Treasury Index is presently a 2.81%, down from a 3.62% from the beginning of the year.  The yield curve has flattened as the 30-year has tightened 68 basis points from the beginning of the year while the 2-year has widened 13 basis points.  Year-to-date the S&P/BGCantor Current 30 Year U.S. Treasury Bond Index has returned 15.54%

The story continues for the comparison of performance between investment grade and high yield.  Last week investment grade bonds as measured by the S&P U.S. Issued Investment Grade Corporate Bond Index, added a positive 0.18% of total return and has now returned 0.27% on the month and 5.87% year-to-date.  Meanwhile, high yield bonds represented by the S&P U.S. Issued High Yield Corporate Bond Index lost -0.48% on the week and are now down -0.64% for the month and have dropped from earlier higher levels to a year-to-date return of 4.87%.

Both investment grade and high yield saw a significant amount of new issuance over the week.  Names such as Bank of Nova Scotia, CSX, Toyota Motor Credit and Morgan Stanley for investment grade issuers and high yield issuer of American Energy Permian Basin, MHGE Parent, Rex Energy and Viking Cruises added to the supply of bonds for last week.

The senior loan market continues to chug along as the S&P/LSTA U.S. Leveraged Loan 100 Index holds steady returning 2.49% year-to-date with a yield of 4.36%.

This week’s economic calendar should bring more insight into the health and pace of the economic recovery.  Today’s Chicago Fed National Activity Index reported a 0.12, much lower than the 0.18 expected.  Last month’s number of 0.16 was revised downward from a 0.21 and continues to drop from March’s recent high of 0.56.  Tomorrow will bring the reporting of CPI which is expected to be 0.3% but may surprise as the reported number has been increasing since March and the pace of inflation has been a topic of discussion with some questioning whether the rate of rising inflation is faster than the Fed realizes.  In addition to CPI, Tuesday’s reports include Existing Home Sales (4.99m exp. vs. 4.89m prior) and the Richmond Fed Manufacturing Index (5 exp. vs. 3 prior).  Only one number will be reported for Wednesday which will be the MBA Mortgage Applications (-3.6% prior).  Though the end of the week picks up as Thursday’s Initial Jobless Claims (307k exp. vs 302k prior), Continuing Claims (2510k exp. vs 2507k prior), and New Home Sales (475k exp. vs 504k prior) should keep markets busy right into Friday.  Friday will see the release of Durable Goods (0.5% vs. -0.9% revised) along with Capital Goods New Orders Nondefense (0.5% exp. vs 0.7% prior).

Source: S&P Dow Jones Indices, Data as of 7/18/2014; Leveraged Loan data as of 7/20/2014.

 

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

S&P 500 Pensions and OPEB: good for companies, not good for our retirement

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Howard Silverblatt

Senior Index Analyst, Product Management

S&P Dow Jones Indices

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S&P has released their annual S&P 500 Pension report (which is available on its website at www.spdji.com or directly at bit.ly/1jPIDiE ). The short bottom line is that, in aggregate, pensions and OPEBs have become an acceptable and manageable expense for S&P 500 issues with respect to their underlying assets, earnings and cash-flow. For individuals, the additional responsibility has been shifted from corporations to them for pensions, and is already well underway for OPEBs, with the government, directly or indirectly, the ‘insurer’ of last resort – and individuals, directly or indirectly, the ‘insurer’ of the government. Some of the findings of the report are:

• Global equity markets continued to post double-digit gains in 2013, as the S&P 500 rose 29.60% (13.41% in 2012) and the S&P Global BMI Ex-U.S. posted a gain of 13.39% (14.05% in 2012). These gains, while significantly adding to assets, were insufficient to counter the increase in liabilities due to artificially low interest rates. Year-over-year comparisons from 2012 to 2013 indicate the following

• Pension underfunding was cut in half, decreasing to USD 224 billion (USD 218 billion deficit in 2002) from the record USD 452 billion

• The pension funding rate increased to 87.8% from 77.3%

• The discount rate increased to 4.69% from 3.93%

• The expected return rate declined to 7.10% from 7.31%, the 13th consecutive annual decline

• Funds tilted toward equities in their 2014 allocations, but they remained cautious of risk

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

Climate Change May Destroy The Risk Premium

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Jodie Gunzberg

Managing Director, Head of U.S. Equities

S&P Dow Jones Indices

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I fear the risk premium for agriculture and livestock may vanish sometime soon as climate change and El Nino drive up food prices.

When investing in commodities as an asset class there are five components of return to be earned by using futures.

5 Commodity Return Sources

While each component’s contribution to performance varies through time depending on the environment, the risk premium is one of the most important sources of return.  It comes from the discount that commercial consumers demand from commercial producers by buying commodities forward.  This is demonstrated in the chart below where, in February, a cattleman and meatpacker agree on a price of 70 cents per pound of cattle for future delivery, when in fact, they also agree the expected cash price at the time will be 72 cents per pound. This 2 cents discount is demanded by the meatpacker for locking in the purchase ahead of time but accepted by the cattleman as insurance for delivery in the future (shown as October in the chart.)

SOURCE: Greer, Robert J., Editor. The Handbook of Inflation hedging Investments, Enhance Performance and Protect Your Portfolio from Inflation Risk. Greer, Robert J. Author, Chapter 5: Commodity Indexes for Real Return. Published by McGraw Hill, January 2006.Sample for illustrative purposes only.
SOURCE: Greer, Robert J., Editor. The Handbook of Inflation hedging Investments, Enhance Performance and Protect Your Portfolio from Inflation Risk. Greer, Robert J. Author, Chapter 5: Commodity Indexes for Real Return. Published by McGraw Hill, January 2006. Sample for illustrative purposes only.

However there are choices the commercial consumer, or meatpacker, in this example has that the producers don’t have.  I have talked about this before in a prior post regarding risks long-only commodity index investors take but believe it is worth revisiting.

The insurance risk premium is available to long-only commodity index investors since there is a gap that needs to be filled between producers and commercial consumers that are hedging. Remember, the futures markets exist to facilitate hedging, not to forecast prices. The producers go short to protect against price drops and the consumers go long to protect against price increases. However, the producers need protection against price drops more than consumers need protection against price increases. The reason this is the case is supported by two economic theories: 1. Hicks’ theory of congenital weakness that argues it is easier for consumers to choose alternatives so they are less vulnerable to price increases than producers are to price drops, and 2. Keynes’ theory of “normal backwardation” that argues producers sell commodities in advance at a discount which causes downward price pressure, which converges to the spot at the time of delivery.  This results in net short hedging pressure from physical users as shown in the graph below:

Hedging Pressure

In other words, long-only investors get paid to supply insurance to producers where commercial consumers choose not to hedge. It is apparent from recent news about price increases for retail consumers of food and beverages like meat, coffee and chocolate, that commercial consumers like Hershey, Starbucks, Kraft’s Maxwell House, J.M. Smucker’s Folgers and Dunkin’ Donuts have chosen to pass through the price increases rather than hedge completely.

Given the expectation that climate change and El Nino may drive up agriculture and livestock prices even further, the question becomes:

At what point will the commercial consumers increase their hedging so that they erase the risk premium opportunity for long only investors by filling the gap created by choices of substitution and passing through the price rises? One answer is when prices get high enough so that retail investors stop buying. When this happens, commercial consumers may increase hedging that effectively provides all the insurance producers need so that investors get paid nothing from this source of return in food commodities.

 

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

Weighing In: On Inflation

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Jodie Gunzberg

Managing Director, Head of U.S. Equities

S&P Dow Jones Indices

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In my last post, I introduced a series called “Weighing In:” that includes comparisons of the effectiveness of the Dow Jones Commodity Index (DJCI) and the S&P GSCI to reach certain portfolio goals.  Although there are a number of reasons investors use commodities, diversification and inflation protection are the two most common.

According to Blu Putnam, Managing Director and Chief Economist, of our partner, CME Group, it may be reasonable to expect inflation later this year or in early 2015.  He states concisely in a video and more in-depth in his paper, “in order for monetary policy to gain traction, the economy must be interest-rate sensitive, and this linkage is missing during a deleveraging period. We believe the US was largely over the deleveraging phase by the end 2012 or early 2013, so as the US economy becomes more interest-rate sensitive, monetary policy with near-zero short-term rates will gain traction. If economist Milton Friedman was right about the long and variable lags in monetary policy, then it is probably appropriate to start the clock at the beginning of 2013, and thus, to expect some inflation pressures 18-24 months later – late 2014 or early 2015.”

Now that we are in the second half of 2014, it may be time to start thinking about commodities as a tool for inflation hedging.  It is natural to guess commodities can be used for inflation protection given the same food and energy that are in the Consumer Price Index (CPI) are in the commodity indices.  However, let’s examine the impact of the composition inside the indices to determine whether the equal sector weighted DJCI or world production weighted S&P GSCI does a better job at protecting against inflation.

Notice in the chart below, the strikingly similar pattern of CPI year-over-year (yoy%), S&P GSCI yoy% and DJCI yoy%.

Source: S&P Dow Jones Indices and Bureau of Labor Statistics http://www.bls.gov/cpi/cpi_sup.htm. Data from Jan 2000 to Dec 2013. Past performance is not an indication of future results.
Source: S&P Dow Jones Indices and Bureau of Labor Statistics http://www.bls.gov/cpi/cpi_sup.htm. Data from Jan 2000 to Dec 2013. Past performance is not an indication of future results.

When using yoy% numbers back to Jan 2000, as far as historical data allows, the correlation between CPI yoy% and S&P GSCI yoy% equals 0.73 and the correlation between CPI yoy% and DJCI yoy% equals 0.69.  Over shorter periods of time, including 10 years and 5 years from year end 2013, the correlation increases for both but more significantly for the S&P GSCI. The 10 year and 5 year correlation, respectively, with CPI yoy% for the S&P GSCI yoy% equals 0.77 and 0.84, and for the DJCI yoy% equals 0.70 and 0.72.

While there is a clear relationship between commodity index returns and inflation changes, what is even more interesting is how much inflation protection the commodity indices provide. For a very small allocation to commodity indices, the inflation protection benefit has been relativelively large. We measure this using a concept called inflation beta, which is a measure of sensitivity of commodity index returns to changes of inflation. It is similar to equity beta, where for example, if a stock moves up and down with the S&P 500 and is more volatile than the S&P 500, the beta is greater than 1.  Inflation beta uses CPI as the benchmark rather than the S&P 500. Please see the table below for the inflation beta of commodity indices:

Source: S&P Dow Jones Indices and Bureau of Labor Statistics http://www.bls.gov/cpi/cpi_sup.htm. Data from Jan 2000 to Dec 2013. Past performance is not an indication of future results.
Source: S&P Dow Jones Indices and Bureau of Labor Statistics http://www.bls.gov/cpi/cpi_sup.htm. Data from Jan 1971 to Dec 2013. Past performance is not an indication of future results.

Since food and energy typically represent a higher percentage of commodity indices than of the CPI, one dollar of investment in a commodity index provides a basis for more than one dollar’s worth of inflation protection. In this chart, the inflation beta can be interpreted as a 1% increase in inflation results in 11.0% increase in return of the DJCI and a 15.3% increase in return of the S&P GSCI during the period from 2000 through 2013.  

Notice the S&P GSCI increase in inflation beta of the S&P GSCI from 2.8 to 13.0 in the time period that starts in 1971 versus the time period starting in 1987. This increase is directly from the addition of oil into the index and is no surprise since energy is the most volatile component of CPI and energy is used to produce every other commodity. The world production weighting scheme of the S&P GSCI that yields a higher energy weight results in a greater inflation beta than the DJCI, though the inflation betas of over 10.0 from the DJCI are significant.

This also holds true for inflation betas around the world, except in places where the prices are independent of the economy. For example, the Mexican government sets the price of gasoline so returns of commodity indices are not considered an inflation hedge against changes in Mexican CPI. This is shown in the chart below:

Source: S&P Dow Jones Indices, Bloomberg and Bureau of Labor Statistics http://www.bls.gov/cpi/cpi_sup.htm. Data from Jan 2004 to Dec 2013. Past performance is not an indication of future results.
Source: S&P Dow Jones Indices, Bloomberg and Bureau of Labor Statistics http://www.bls.gov/cpi/cpi_sup.htm. Data from Jan 2004 to Dec 2013. Past performance is not an indication of future results.

Overall, from the analysis, both the S&P GSCI and the DJCI are strong inflation protectors. However, the S&P GSCI is a stronger inflation hedging tool given its energy weight.

 

 

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