Indexology^® Blog

The growing popularity of sukuk is reflected in the recent strong index performance.The Dow Jones Sukuk Index delivered a total return of 7.08% year-on-year (Y-o-Y) and 5.26% year-to-date (YTD), as of August 18, 2014. The index’s yield-to-maturity also tightened by 51bps YTD to 2.55%. Noticeably, the yield of the S&P MENA Sukuk Index dropped 55bps YTD to 2.33%, which is almost on par with the yield of Dow Jones Sukuk Higher Quality Investment Grade Index. Please see Exhibit 1 for the yield comparison.

Exhibit 1: The Yield-to-Maturity Comparison of the Dow Jones Sukuk Index 

According to the rating based and maturity based sub-indices of the Dow Jones Sukuk Index family, the sukuk with longer maturities and lower ratings outperformed the market. The Dow Jones Sukuk 7-10 Year Index rose 11.1% Y-o-Y and 9.60% YTD, while the Dow Jones Sukuk BBB Rated Index gained 9.44% Y-o-Y and 7.03% YTD. In search of higher yields, investors tend to go further out on the risk spectrum, see Exhibit 2.

Exhibit 2: The Rating Based Sub-Indices of the Dow Jones Sukuk Index 

The market size tracked by the Dow Jones Sukuk Index expanded 23% YTD to USD43 billion. The new names tapping into the market are Export-Import Bank of Malaysia and Emaar Malls from UAE, together with returning issuers such as Islamic Development Bank and Saudi Electricity. The continued growth is fueled by ongoing financing needs, solid investor demand and more importantly, the regulatory support.

The issuance pipeline remains robust; for example, Indonesia sovereign just released a preliminary OC on a USD Sukuk, which is rated “BB+” by S&P Ratings. The Malaysia Airports also announced a perpetual subordinated sukuk that is denominated in Malaysian Ringgit.

High Yield Bond Market – Outlook has changed to the positive, away from the recent stories of overvaluation and fund withdrawals.

The S&P U.S. Issued High Yield Corporate Bond Index returned 1% last week and a 0.43% the week before to recover the loss incurred the last week of July (-1.38%).  Year-to-date the index is returning 5.10%.  As entitled in Katy Burne’s Wall Street Journal article, “Big Investors Snap Up Junk Bonds,” institutional investors have stepped up their buying, seeing value in current prices after the recent sell-off.

Investment Grade Market – Issuance has been heavy.

Names like American Express, American Water Capital, Burlington Northern, CBS Corp, Motorola, Prudential and UBS came to market.  The total market value of the S&P U.S. Issued Investment Grade Corporate Bond Index has increased by almost 10% since the beginning of the year.  The index has returned 1.10% month-to-date and 6.76% this year.

Treasury yields backed off this morning.

Yields rose 2.38% in response to the easing of geopolitical events after tightening all last week.  The yield of the S&P/BGCantor Current 10 Year U.S. Treasury Bond Index tightened from 2.42% to 2.33% last week.The index is now returning 8.34% year-to-date.

The Treasury auction calendar for this week contains the weekly Bill auctions along with $16 billion 5-year TIPS.  Next week’s calendar is full of auctions, as 2-year fixed and floating along with 5 and 7-year auctions are scheduled.

The economic calendar for the week ahead is loaded with significant indicators.  Today’s NAHB Housing Market Index for August reported a 55, stronger than the expected 53 which was the prior July number.  CPI for July is expected to be 0.1% tomorrow, after last month’s 0.26% broke a string of increasing values going back to March.  In addition to CPI, Housing starts are expected to rise to a 966k from the prior 893k, while an increase in the Building Permits release is expected to be 1,000k.  Wednesday is the focal point of the week as the Fed will release the meeting notes of the July 29^th / 30^th FOMC meeting.  On Thursday, the following releases will close out the week:  August 16^th Initial Jobless (2520k exp.), the Philadelphia Fed Business Outlook (19.4 vs. the prior 23.9), Existing Home Sales (5.01m exp. vs. 5.04m prior) and the Conference Board U.S. Leading Indicator Index (0.6% exp.)

Source: S&P Dow Jones Indices, data as of 8/15/2014

One of the most significant changes made by the Affordable Care Act (ACA) was in the individual health insurance market, where the law eliminated the traditional medical underwriting processes and required health carriers to accept all applicants, regardless of their health conditions. The impact of these changes on the cost of individual health insurance has been hotly debated, but until now, the debate has been speculative due to the lack of actual claims data.  The July update on the S&P DJI Healthcare Claims indices provides the first credible claims based evidence showing the impact of the ACA changes on the cost of individual health insurance.

Since 2010, the annual rate of increase in health care claim costs (claim trend) has been steady at approximately 5% or less for group (employer) health coverage, while individual claim trends have been in the 5% to 10% range. For the first three months of 2014, the group trends have shown a slight decline, while the claim trend for individual coverage has increased to over 15% on an annualized basis. The increase in year over year claim costs for individual coverage is consistent when costs are broken down by type of service. For example, the S&P DJI July index trend for prescription drugs is over 30% for individual coverage (versus about 5% for group coverage) and the trend for professional services is above 10% (versus a 0% or negative trend for group coverage). This divergence in cost trends between group and individual health insurance has not been seen previously and is almost certainly due to the ACA changes.

The S&P DJI index trends are particularly timely, since the health insurance carriers are preparing to finalize their 2015 rates for individual coverage during August. The concern that the carriers must address as they prepare their 2015 premium rates for the public exchanges is at what level the emerging claim trends will stabilize and how those trends will impact their financial position.

Next week will be a double dose of Fed speculation and debate. First, on Wednesday at 2 PM the Fed will release the minutes from the last FOMC meeting on July 29^th-30^th.  Then on Thursday evening, Friday and Saturday the Kansas City Fed will hold its annual economic policy symposium in Jackson Hole Wyoming.   The symposium usually attracts a who’s-who of international monetary policy and central banking.  While the topic for this year, “Re-Evaluating Labor Market Dynamics” has been announced, the agenda and the speakers won’t be revealed until the evening of August 21^st. However, Janet Yellen is certain to be someplace on the program; Stanley Fischer, Vice-chair of the Fed, might also speak along with some academics and foreign central bankers.

Labor market dynamics – will the unemployment rate keep falling, what is the right number for full employment and what will make wages rise enough to spark inflation anxiety – are one of three key Fed issues expected to dominate both next week and the rest of this year. The other two are when will interest rates rise and how will the Fed manage to control them.  After all the symposium’s economic theory and econometrics fade away two questions will remain: Will the improving labor market spark inflation? Will rising interest rates reverse recent labor gains?  If we believe recent statements by Janet Yellen, she sees little worry about the first question for 2014 or 2015, but has some concern about the second question which is wrapped up with how the Fed will raise interest rates.

Even though labor markets are the focus of the Kansas City Fed meetings, both interest rates and operating procedures will be discussed – during the breaks if not in the formal sessions.  Not everyone is as sanguine as the Fed chairwoman that unemployment can continue to fall and wages can rise without an immediate inflation penalty.  There is a more hawkish segment to both the FOMC and the meetings that will argue for an earlier effort to raise interest rates. Despite this, there is little evidence that the Fed will move before sometime in 2015, probably in the second or third quarters.  The truth is that no one knows — or can know – because it depends on how the economy unfolds going forward.

The last puzzle is what the Fed should do to raise interest rates.  Back before the financial crisis and QE 1-2-3 the Fed could adjust interest rates by adding or draining bank reserves from the nation’s banking system.  That worked than because the bank reserves were near the margin where a small drain would push the Fed funds rate up and a modest addition would send it down.  No longer.  Following quantitative easing, the banking system is awash in reserves and there is no way the Fed can drain enough to make a difference.  There are other approaches available: adjusting the interest rate the Fed pays to banks on excess reserves held at the Fed is one, auctioning reverse repurchase agreements is another.  These will work, but with little experience the central bank could overshoot the target or miss completely.   Like the Fed, the market has little experience with these new operating procedures.  When the Fed does raise interest rates, will the market know how to respond or will it over react and send rates either surging or collapsing.  The answer to that question may be the topic for the 2015 Kansas City Fed conference.

Sector allocation is one of the main pillars of equity portfolio management, and its use as a strategy to optimize investment allocations through sector rotation is increasingly abundant. In Australia, the equity market is diversified in sectors, and some of them can be traded through exchange-traded funds, making it possible to implement a rotation strategy.

Based on the S&P/ASX 200, financials is the biggest sector in the Australian equity market by index weight (46%), consisting of 41 stocks traded with a combined value of more than AUD 1.4 billion daily. Information technology (I.T.) is the smallest sector, weighting merely 0.7% and containing three stocks traded with a daily combined value of AUD 26 million.

Despite the fact that the Australian equity market is dominated by the financials and materials sectors, historically, neither of these has persistently outperformed other sectors. Based on annual sector returns in the past 24 years from 1990 to 2013, we observed that sector leaders and laggards rotated every year and no single sector could consistently outperform the rest for extended periods of time. Utilities had the highest annualized return in the entire period, but its annual performance ranked within the top three only in 11 years—less than half of the time over the observed interval. Since sectors can fall in and out of favor, a sector rotation strategy that attempts to identify future sector leaders and laggards could be beneficial.

Our study on sector price momentum strategy shows that sectors with stronger price momentum in recent months tend to outperform in coming months. On the other hand, sectors with weaker price momentum in recent months are more likely to lag behind the market in the next months. A simple, long-only price momentum strategy to invest quarterly in the top three sectors based on a 12-month price change generated an annualized excess return of 4.6% when compared to the benchmark, from December 1990 to June 2014.

Historical Performance and Annual Return of 12-Month Strong and Weak Price Momentum Portfolios

Source: S&P Dow Jones Indices LLC. Data from December 1990 to June 2014. Data are based on the S&P/ASX 200 universe (between March 31, 2000, and June 30, 2014) and the S&P Australia BMI universe (prior to March 31, 2000). Sectors in portfolios are equal-weighted and stocks within each sector are market cap weighted. Performance is based on total return in AUD. Charts and tables are provided for illustrative purposes. Past performance is no guarantee of future results.

Like any typical price momentum strategy, sector price momentum strategy can also result in high portfolio turnover. Without optimization for lower turnover, the 12-month price momentum portfolio in our study recorded 129% annualized turnover. By assuming a one-way replication cost of 50 bps, the annualized return of the 12-month price momentum strategy would decrease by 1.29% to 3.3%. This non-optimized simple strategy remained profitable after replication costs.