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Canada Yields Hit Low And Go Higher

Inside Factors: Value Investing

Global Factors Have Been Driving the Mexican Bond Market

Inside the Dow: Apple

Higher Interest Rates: Why, When, How

Canada Yields Hit Low And Go Higher

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Kevin Horan

Director, Fixed Income Indices

S&P Dow Jones Indices

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The yield-to-worst of the S&P Canada Aggregate Bond Index touched a low of 1.53% on February 2, 2015 after 10 years of history in which the index’s yield had been as high as 4.96% back in June 2007.  After a solid total return of 4.35% in January, the index gave up a little ground and returned -0.11% for February.  March has come in like a lion, as it has wiped out 2% of returns as of March 6, 2015.  As of the same date, the index is returning 2.15% YTD.

The components of the S&P Canada Aggregate Bond Index are all wider by an average of 29 bps as of March 6, 2015; S&P Canada Sovereign Bond Index (28 bps), S&P Canada Provincial & Municipal Bond Index (32bps), S&P Canada Investment Grade Corporate Bond Index
(26 bps), and  S&P Canada Collateralized Bond Index (32 bps).

Last week, Canadian bonds sold off for the entire week.  The Bank of Canada held its policy interest rate unchanged at 0.75%, and backed up the no action with statements that the level is the appropriate rate.  This is in contrast to the Jan.  21, 2015 cut of 25 bps from the 1% level in response to lower oil prices.  The rate cut was a complete reversal of policy and tone for the BOC.

After a stellar 2014 in which the S&P Canada Provincial & Municipal Bond Index returned 10.48%, this index is still out in front as of March 6, 2015, returning 2.76% YTD.  Provincials & Municipals Index had a strong January (+5.58%), although they are getting hit the hardest in March, at -2.57% as of March 6, 2015.

The best performer in the recent downtrend has been the S&P Canada Collateralized Bond Index losing only -0.39% of return MTD.
Canada Yield-to-Worst History

Source: S&P Dow Jones Indices LLC.  Data as of March 6, 2015.  Past performance is no guarantee of future results.  Charts and graphs are provided for illustrative purposes.

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

Inside Factors: Value Investing

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Sunjiv Mainie

Managing Director, Global Research & Design

S&P Dow Jones Indices

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The godfathers of value investing, Graham and Dodd, pioneered the approach back in the 1930s. Since then, academics and practitioners have documented the value effect. However, given its widespread adoption and implementation, there is still no single consensus as to why value stocks provide above-market returns. Explanations broadly fall into two camps: the rational and the behavioural.

Rational theories explain how the value premium arises from investors requiring compensation for bearing higher systemic risk in the form of financial distress (Fama and French 1996).[1] For example, in recessionary environments, value firms (like manufacturing) find it difficult to shift their activities to more profitable ones. By contrast, growth firms (such as technology) can disinvest relatively easily, as a large proportion of their capital is human capital. Hence, value firms are perceived as being riskier than their growth counterparts and, as such, should command a premium.

Behavioural theories argue that the value risk premium might be driven by investors incorrectly extrapolating the past earnings growth rates of companies (Lakonishok et al. 1994).[2] High profile, glamorous stocks that have high valuations are bought by naïve investors expecting continued high growth rates in earnings. This pushes up their prices and, as a consequence, lowers their rates of return. At the same time, value stocks are cheap, as investors underestimate their future growth rates. Their cheapness does not arise from the fact that they are fundamentally riskier.

There are many ways to define value. For example, cash-flow yield and earnings yield examine cheapness while emphasizing profitability. Dividend yield provides insight into management’s assessment of future profitability. Using the balance sheet item of net assets (book) gives a measure of liquidation value. Other value measures include predicted earnings yield and EBITDA[3]-to-enterprise value. Equity products that aim to harvest the value premium can be constructed by using one or a combination of these measures.[4]

The soon-to-be-launched S&P Enhanced Value Indices* are an example of indices seeking to capture the value risk premium. They combine price-to-book, price-to-earnings, and price-to-sales (using the Z-score method) and select the top quintile of cheapest stocks. Constituent weights are computed as the product of the overall value score and the float-adjusted market capitalisation. Exhibit 1 displays the Sharpe ratios of the S&P Enhanced Value Indices and the relevant S&P BMI Indices over the past 15 years.

Capture

Exhibit 1 shows the successful capture of the value risk premium over the analyzed period.

For further insights, please register for one of our complimentary European seminars, entitled “Is Factor Investing a New Haven?

*Index launch expected no later than April 2015.

[1] Fama, E.F. and French, K.R., (1996). Multifactor Explanations of Asset Pricing Anomalies. Journal of Finance. 51, 55-84.

[2] Lakonishok, J., Shleifer, A.,Vishny, R. W., (1994). Contrarian Investment, Exptrapolation, and Risk. Journal of Finance. Vol 69 (5), 1541-1578.

[3]   EBITDA: earnings before interest, tax, depreciation, and amortization.

[4]   Combining different factors (measures) can be achieved through the Z-score method. A Z-score is a stock’s standardized exposure to a factor. For each stock in an investment universe, subtract the universe’s mean factor exposure from the individual stock’s factor exposure. Then divide this number by the standard deviation of the factor exposures for the universe. Z-scores can then be added to derive an overall score and subsequent exposure to a set of factors.

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

Global Factors Have Been Driving the Mexican Bond Market

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Jaime Merino

Director, Asset Owners Channel

S&P Dow Jones Indices

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There is a Mexican saying about the weather, “Febrero loco, Marzo otro poco,” which means, “February is crazy and March is even more”.  I didn’t think about applying this to financial markets until now, with the European Central Bank (ECB) announcement, economic data in the U.S., inflation in Mexico, and last but not the least, the Fed’s monetary policy announcement.

Having announced that the ECB will stimulate its economy through additional purchases, bonds have seen increased demand recently.  Then, all eyes were on U.S. employment data, with the positive economic news that non-farm payrolls were up 25% more than expected (the estimate was for 235,000 jobs, and the actual level was 295,000).  One business day later, Mexico published its CPI for February that showed a 3.00% annual change, versus the 3.03% estimate; remember, the objective of the Mexican Central Bank (Banxico) is between 2% and 4%.  A few days ago, the Fed’s “patience” was over.  The question is: will Banxico take action before or after the Fed?  Looking at the CPI and level of the Mexican peso could point in that direction.

In March 2015, the Mexican 10-year reference bond has increased 25 bps to 5.88% from 5.63% (with a 19 bps average in the whole curve), with a closing high of 6.10% on March 10, 2015, with a 6.26% intraday level that day, causing the S&P/Valmer Mexico Government MBONOS Index to lose 0.97% (17.44% annualized).  Real rates also have moved significantly in March 2015, increasing 24 bps and causing the S&P/Valmer Mexico Government Inflation-Linked UDIBONOS Index to lose 1.59% (28.55% annualized).

The Mexican peso has depreciated by 2.13% since the start of the month, from 14.95 to the March 19, 2015, close of 15.27.  On March 20, 2015, the currency is down 1.52% (15.04).  Continued currency depreciation of the peso means that the strength of the U.S. dollar has helped the return of the S&P/Valmer Mexico Government International 1+ Year UMS Index to be less of a loss, at 17.05% annualized.

Of note, this week’s auction of government bonds had its highest bid-to-cover ratio since November 2014; it seems that depreciation of the currency hasn’t stopped the inflows.

With all that is happening, don’t forget to watch the movements and thoughts of the analysts in the Banamex Survey of Economists was published on March 20.

Capture

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

Inside the Dow: Apple

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David Blitzer

Managing Director and Chairman of the Index Committee

S&P Dow Jones Indices

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On Friday S&P Dow Jones Indices announced that Apple will be added to the Dow Jones Industrial Average after the market close on March 18th.

What’s in it for Apple

Apple was certainly well-known last week before the announcement that it will join the DJIA.  However, its entry into an exclusive club defined by The Dow, the oldest and most followed market measure, still confers more recognition. One comment on Seeking Alpha said Apple is now an adult.  There may not be a universal definition of what a Blue Chip stock is, but no one will argue now that Apple doesn’t qualify.  Much the same could be said for the other companies in the DJIA – any company joining The Dow is already an established leader with a history of success.

One thing that Apple isn’t likely to get by joining the Dow is a pop in its stock.  At times in the past companies being added to one of a few key indices saw their stock gain as index funds and ETFs tracking the index bought shares.  The “index effect” or “index pop” has been widely studied in the S&P 500®.   In recent years some stocks joining the S&P 500 experienced a temporary gain of 3%-6% which was given back over the next few months.  The funds tracking the S&P 500 are orders of magnitude greater than the approximately $30 billion tracking The Dow.  Not enough buying is likely to be generated to even briefly move a stock as large as Apple.

While there is no price or index effect, there is a “list effect” for both The Dow and the S&P 500. Apple is now on the list of Blue Chips — when a journalist wants to talk to a leading company or try to interview a famous CEO she will look at the list. The same is probably true of a Congressman seeking a campaign stop that will get him on the evening news or in someone’s Twitter feed.  One advantage of The Dow list  compared to the S&P 500 list is that the former isn’t likely to be used as a hunting ground for takeover targets.  More than half the exits from the S&P 500 are caused by companies being taken over, often by another company in the same index.

What’s in it for The Dow

The market changes, the economy shifts and the Dow changes as well.  Only one company, GE, of the current 30 is an original member from 1896, and it is very different today from what it was 119 years ago.  Adding Apple to The Dow is another change in a long list off entries and exits that keep the DJIA representative of current Blue Chips.  As long as the economy grows and the markets change, there will be more changes to The Dow.

The addition of Apple was supported by more suggestions, arguments and advice that it belongs in The Dow than most previous changes.  At the same time, it would have been quite difficult to add Apple if it hadn’t split its stock seven for one in June 2014. Whether one reason for the split to make Dow membership possible is a question for Apple, not S&P Dow Jones Indices.   We don’t discuss possible index changes with the companies affected or with anyone outside of the committee overseeing the particular index.

What About AT&T

The Dow has 30 members and adding one means removing another.  The decision to add, or remove, a stock from the The Dow (or any other index) is not an investment opinion. No buy/hold/sell.  The decision is based on what can make the index a better market measure.  There were two telecommunication companies in The Dow – AT&T and Verizon – and the decision on which to remove was based AT&T’s lower stock price. Since The Dow is price weighted, the lower a stock price, the less impact on the index.

An analysis in Seeking Alpha noted that stocks exiting from The Dow often do well. Just as being added to an index gets a stock noticed, being removed can also generate some investor interest.  Some investors believe that by the time a stock joins an index; its price has already risen while those leaving may be ready to rebound.

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

Higher Interest Rates: Why, When, How

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David Blitzer

Managing Director and Chairman of the Index Committee

S&P Dow Jones Indices

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Three issues surround the debate over the Fed and raising interest rates: why should interest rates be increased? When should they be raised and how can the Fed do it.  All three need to be resolved.

Why

The traditional description of Fed policy is “removing the punchbowl when the party gets good.” The Fed’s dual mandate of employment and stable prices is a balancing act between competing goals.  With the economy growing, employment rising and unemployment under 6%, attention is shifting to prices.  With a more upbeat economy comes expectations of higher inflation and upward pressure on prices and wages.  Inflation depends on how aggressively business tries to raise prices. The objective in raising interest rates is lower expectations of future inflation to limit efforts to raise prices.  Neither the size nor the growth of the money supply completely determines inflation rates.  Those who believe that the money supply is the only factor behind inflation must explain why inflation is currently so low after five years of unusually high money supply growth.

The Fed funds rate affects the economy and financial markets, not just inflation expectations. The Fed’s three rounds of large scale asset purchases – popularly known as QE or quantitative easing – pushed the Fed funds rate to almost zero (see chart) and were a crucial factor in the economic recovery. QE worked by keeping interest rates artificially low and boosting prices of stocks, homes and other assets. However, zero interest rates distort prices and returns in financial markets.   With the economy doing better, the Fed wants to normalize interest rates and move the fed funds rate from almost zero to something a bit higher.

A “normal” level for the Fed funds rate depends on inflation, employment and the economy. One widely followed definition of a normal Fed funds rate is the Taylor rule based on analysis of Fed rate setting by John Taylor, a Stanford University economist.  The chart, based on calculations of the Taylor rule by the St Louis Federal Reserve Bank, compares the rule to the past and current Fed funds rate, suggesting the the Fed funds rate should be raised. However, the central bank is not in a rush, will probably take small steps of a quarter percentage point at a time.

Source: Federal Reserve Bank of St.Louis
Source: Federal Reserve Bank of St.Louis

How

The last time the Fed raised the Fed funds target was July 2006. Back then the level of excess reserves – funds banks have on deposit at the Fed that exceed the level of reserves mandated by law, was small.  The Fed funds rate is what banks pay when they borrow or lend reserves to one-another. Before QE, the central bank could sell securities to drain funds from the banking system, raising the cost of borrowing needed reserves. After three rounds of QE, excess reserves are close to $3 trillion, far too large for the Fed to nudge rates higher by selling securities.

With the advent of QE, some questioned whether the central bank would be able to control interest rates until QE was reversed and $3 trillion of reserves somehow vanished. Last fall the Fed announced new operating procedures for managing the Fed funds rate.  The ceiling on the Fed funds rate is set by the interest rate the Fed pays banks on excess reserves on deposit at the Fed.  With the Fed paying one-quarter percent on excess reserves, there is no reason for a bank to lend overnight to anyone else at a lower rate.  The floor is set by reverse repurchase agreements (RRP) where the Fed sells securities and agrees to buy them back at a slightly higher price, the difference determining the interest rate. The availability of RRPs encourages non-banks with funds to invest not to seek a return lower than the RRP rate.  Paying interest on reserves has been in place for a few years, the RRP process has been tested. The Fed can manage the Fed funds rate.

When

Friday’s Employment Report of 295,000 jobs added in February is merely the latest piece of strong economic news.  The unemployment at 5.5%, also reported in Friday’s Employment data, is in the range that the Fed terms as full employment – it would be nice to see it move lower, but the risk of inflation might move up from here.  At the same time, wages are still not rising much, if at all, so there is no immediate reason for the Fed to act.  Most forecasts look for the Fed to raise interest rates in the second half of 2015, a few suggest as early as June and some as far away as 2016.  Among those Fed members who have comments, the same wide range holds.

Friday also gave the markets a taste of things to come: the Employment Report spooked investors and sent major equity indices tumbling.   Zero interest rates can’t go on forever; something that can’t go on forever must, sooner or later, come to an end.  The Fed will raise interest rates, no one (not even Janet Yellen) knows when. And, until the Fed acts there will be moments like Friday when the fear of rising rates scares markets.

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