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The Rieger Report: 2015 Headwinds & Tailwinds for Municipal Bonds

The Rieger Report: Municipal Bonds and the Taxman

U.S. Preferred Stock: Equity & Bond Characteristics Helping or Hurting Performance?

Hedging Geopolitical Risk With Oil

Dreams to Sell

The Rieger Report: 2015 Headwinds & Tailwinds for Municipal Bonds

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J.R. Rieger

Head of Fixed Income Indices

S&P Dow Jones Indices

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As we near the end of the first quarter, investment grade tax-exempt bonds tracked in the S&P National AMT-Free Municipal Bond Index have returned 0.93% year-to-date underperforming relative to the over 2% return of the investment grade corporate bond market tracked in the S&P U.S. Investment Grade Corporate Bond Index.

High yield bonds are showing similar results.  The S&P Municipal Bond High Yield Index has returned 1.23% year-to-date while the S&P U.S. High Yield Corporate Bond Index has returned 2.48%.

What is going on?  The reality is that there are both headwinds and tailwinds buffeting the municipal bond market.

First, some potential headwinds for municipal bonds for the rest of 2015:

  • Retail Sentiment: The municipal bond market is heavily driven by retail investor sentiment.  If ‘mom and pop’ don’t like municipal bonds then fund flows will most likely be negative.  The more negative headlines the more likely that retail sentiment turns negative.
  • Puerto Rico:  This is an ugly and complex situation that is likely to lead to some massive defaults of Puerto Rico revenue bonds.  So far, the S&P Municipal Bond Puerto Rico Index has dropped 1.34% in March eroding the previous two months of positive performance.   State bond funds with Puerto Rico bond exposure are impacted on two fronts 1) bond prices falling and 2) possible lack of liquidity when and if they decide to sell the bonds.  The uninsured bonds are included in the S&P Municipal Bond High Yield Index and the recent drop in bond prices is helping to weigh the high yield segment down.  There are no  Puerto Rico bonds in the S&P National AMT-Free Municipal Bond Index.
  • Illinois and New Jersey:  Each of these states has pretty large pension short falls to negotiate and this may result in headline after headline of bad press.
  • Chicago: Is Chicago is the next Detroit? I don’t think so.  However, how the Windy City deals with its budget and obligations is most likely going to be closely watched again creating headlines.
  • Rising Interest Rates: Bonds are bonds, if yields rise bond prices go down.

Some potential tailwinds for municipal bonds in 2015 include:

  • High quality: The investment grade municipal bonds tracked in the S&P National AMT-Free Municipal Bond Index are incrementally higher quality than their corporate counterparts.  Please refer to Should Municipal Bonds Be Considered Core? for more detail.
  • Supply and demand: 
    • No tax relief in sight:  Demand for tax-exempt bonds is in large part driven by the current tax environment.
    • New issue supply:  Demand still outpaces supply. While new issues have been increasing, the volume is partly driven by refunding bonds replacing higher yielding bond issues.
  • Diversification:  There are tens of thousands of municipal bond issuers from small local municipalities to states and territories.  The vast majority are investment grade.  There are over 10,000 bonds tracked in the S&P National AMT-Free Municipal Bond Index and all are investment grade.
  • Comparative yield with less duration risk: Relative to other investment grade fixed income asset classes, investment grade municipal bonds still provide comparative yield when viewed from the Taxable Equivalent Yield perspective.  Using a 35% tax rate the Taxable Equivalent Yield of the S&P National AMT-Free Municipal Bond Index is 2.91% while the yield of taxable bonds in the S&P U.S. Investment Grade Corporate Bond Index is 2.81%.  Meanwhile, the duration of the bonds in the S&P National AMT-Free Municipal Bond Index is 4.7 years nearly two years shorter than its corporate bond index counterpart.
  • Value in the ‘belly of the curve’:  On a nominal yield basis a diversified basket of non-callable investment grade bonds tracked in the S&P AMT-Free Municipal Series 2020 Index (5 year bonds) have a higher yield than the 5 year U.S. Treasury bond.  The same is true for the S&P AMT-Free Municipal Series 2024 index  (9 year bonds) verses the 10 year U.S. Treasury bond yield.   Note: S&P Dow Jones Indices has not yet launched the index tracking non-callable bonds in 2025.

And then there is the Tobacco Settlement bond sector.

  • Tobacco Settlement bonds:  This sector has a split personality – it is both a short term positive return driver and a long term hazard. So far in 2015 tobacco settlement bonds have returned over 3.7% as tracked by the S&P Municipal Bond Tobacco Index.  Recent successful refunding bond issues have certainly helped and no defaults are imminent but the long term future is clouded (I have called it a “dark cloud on the horizon”) as these bonds are dependent upon U.S. sales revenue of tobacco products.  The long duration of bonds in this sector also make it prone to dramatic price changes when yields change.  Tobacco settlement bonds are excluded from the S&P National AMT-Free Municipal Bond Index.

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

The Rieger Report: Municipal Bonds and the Taxman

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J.R. Rieger

Head of Fixed Income Indices

S&P Dow Jones Indices

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The tax season for U.S. taxpayers is upon us.  For bond income what you keep after Uncle Sam takes his share can be more important than what you earn.

Income, Yield and Duration:

  • Investment grade municipal bonds on average have a higher coupon cash flow to bondholders than corporate bonds and that cash flow is exempt from federal taxation.  The average tax-exempt coupon of investment grade bonds in the S&P National AMT-Free Municipal Bond Index is 4.61% while the average taxable coupon of bonds in the S&P U.S. Investment Grade Corporate Bond Index is 4.31%.
  • Tax-exempt municipal bonds have a lower yield than corporate bonds. If a municipal bond and a corporate bond had the same coupon, maturity, quality and other characteristics the municipal bond would have a higher price and lower yield than the corporate bond.  The tax-exempt yield of bonds in the S&P National AMT-Free Municipal Bond Index is 1.88% and corporate bonds in the S&P U.S. Investment Grade Corporate Bond Index are yielding 2.81%.  One yield is representing a tax-free yield (not subject to federal taxes) and the other, the corporate yield, is before taxes are applied to the income.  Another way to look at this would be to put each on an equal footing by using the taxable equivalent yield for municipal bonds.  The taxable equivalent yield of the bonds in the S&P National AMT-Free Municipal Bond Index is 2.89% (assuming a 35% tax rate).  In other words, to find equivalent taxable bonds one would need to find bonds that yield at least 2.89% or higher to keep the same amount of return after taxes.  The higher the tax rate the higher the taxable equivalent yield.   A 40% tax rate shifts the taxable equivalent yield of municipal bonds to over 3.1%.
  • Here is the kicker:  the yield comparison above is unfair to municipal bonds as investment grade municipal bonds on average have a shorter duration than their corporate counterparts.  As we continue to be on the edge of a rising interest rate environment duration remains a key consideration.  The modified duration of bonds in the S&P National AMT-Free Municipal Bond Index is 4.7 years while corporate bonds tracked in the S&P U.S. Investment Grade Corporate Bond Index have a duration of over 6.5 years.  Based on this, corporate bonds should experience more volatility to the down side than municipal bonds if and when rates rise.

The bottom line: A focus on yield is important but it is actually what we get to keep after taxes that helps keep tax-exempt municipal bonds showing their value in this market.

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

U.S. Preferred Stock: Equity & Bond Characteristics Helping or Hurting Performance?

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J.R. Rieger

Head of Fixed Income Indices

S&P Dow Jones Indices

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In this prolonged low interest rate environment, the S&P U.S. Preferred Stock Index has performed well, returning 2.92% year-to-date.   Meanwhile, the S&P 500 (TR) is up a modest 0.6% and long term bonds tracked in the S&P/BGCantor 20+ Year U.S. Treasury Bond Index are up 4.53% in total return.  So far, the preferred stock market with characteristics of both equities and bonds has performed as expected – somewhere in the middle of the performance of stocks and long term bonds.

Select Indices: Year to Date Performance (March 27, 2015):

Source: S&P Dow Jones Indices LLC.  Data as of March 27, 2015.
Source: S&P Dow Jones Indices LLC. Data as of March 27, 2015.

Over a three year period, the annualized returns of the U.S. preferred market have been more bond like than equity like.  The S&P U.S. Preferred Stock Index had a three year annualized return of 7.95% while long U.S. Treasury bonds have returned 8.14%.  Meanwhile, the three year annualized return of the S&P 500 has been well over 15%.

Select Indices: Three Year Performance (March 27, 2015):

Source: S&P Dow Jones Indices, LLC.  Data as of March 27, 2015.
Source: S&P Dow Jones Indices, LLC. Data as of March 27, 2015.

While it is easy to relate the performance of preferred stock and long term bonds to interest rate changes, the two asset classes have shown a low correlation to each other over the last three years.  Actually, the S&P U.S. Preferred Stock Index has had a higher correlation to the S&P 500 than it did to long term to bonds.  There is a danger in just looking at the last three years of course as interest rates have been held low during the period.

Three Year Correlations:

Source: S&P Dow Jones Indices, LLC.  Data as of March 27, 2015.
Source: S&P Dow Jones Indices, LLC. Data as of March 27, 2015.

Will a rising interest rate environment bring the same pain to preferred stocks as it might to long term bonds?  The short term history illustrates that the combined equity and bond like characteristics of preferred stock both play a role in actual performance.  Like all things still to come, we will just have to wait and see how the markets unfold.

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

Hedging Geopolitical Risk With Oil

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Jodie Gunzberg

Managing Director, Head of U.S. Equities

S&P Dow Jones Indices

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This morning, I woke up to the headline Oil just spiked again, on news Saudi Arabia is bombing rebel positions in Yemen. It was the perfect reminder of a call I had earlier in the week from a large pension looking for an oil index to hedge geopolitical risk. After the call, my colleague asked, “Why would an investor use oil to hedge against geopolitical risk?” He continued with more questions like why not use equities or credits from those countries and isn’t it impossible to hedge against geopolitical risk?

In remarks from the Bank of Canada, geopolitical developments often have a major impact on oil prices since they can affect oil supply directly and since the threat of future supply disruptions can also build a risk premium into oil prices. As a notable example, in the early part of 2014, conflicts in Libya and Iraq led to temporary outages in their oil production, keeping world prices high, even as supply elsewhere in the world continued to ramp up. When production from those two countries came back on stream, that was an important trigger for the plunge in oil prices later in the year.

Notice in this chart produced by WTRG Economics the spikes in oil price jumped more than 2 times on average during these critical periods except the first Gulf war.

War Oil History

This behavior is no different today as demonstrated in the chart of oil prices for the past two weeks, hourly. Notice the oil spike from the Yemen bombing, despite the fact it is only the world’s 39th largest producer.

geopolitical risk Yemen

Not only do geopolitical events spike oil (and other commodities) but they may simultaneously hurt the stock market. An article posted by CNN Money just hours ago states, “The surge in oil followed a sharp sell off in the U.S. stock market overnight. European markets were all declining by about 1% to 2% in early trading and most Asian markets closed with losses.” The chart below shows another example of the S&P GSCI rising while the S&P 500 fell during the Persian Gulf War.

geopolitical risk Persian Gulf

Based on the above, oil has historically performed better than stocks in times of war, though stocks have remained relatively flat in many cases as shown in the table below.Stocks War

Although not all the countries with high geopolitical risk are necessarily high yield, there should be a link between them given the methodology from OECD to classify the country risk. According to OECD, “the country risk is composed of transfer and convertibility risk (i.e. the risk a government imposes capital or exchange controls that prevent an entity from converting local currency into foreign currency and/or transferring funds to creditors located outside the country) and cases of force majeure (e.g. war, expropriation, revolution, civil disturbance, floods, earthquakes).”

The high yield market has had a positive correlation with equity markets for many years when comparing the percentage change in spreads (over Treasuries) for key high yield indices vs. the percentage change in level for equities, and this correlation has become even more pronounced since the global financial crisis.

HYStocks

According to PIMCO, equity market volatility and its associated effects on enterprise value have driven high yield spreads. The investment implications of the equity–high yield correlation say that if you expect equity valuations to increase for a certain sector or name – whether based on general growth prospects, a changing environment or new information – then, all else being equal, you could expect credit spreads in that sector or name to decrease in the future. For example, spreads on credits related to metals and mining sectors widened in 2012 from relatively weak equity performance in the sector, mainly due to decreased demand from China.

Even if stocks hold up in war times, it is possible investors will flee high yield bonds first since they may not feel they are getting compensated to take the geopolitical risk. As zerohedge.com points out, “geopolitical risk is causing a pause… Investors tend to flee riskier assets during times of turmoil.” This may cause a decoupling of high yield from stocks as seen in the chart below:

HYStocks Decouple

So if oil is the choice for hedging against geopolitical risk, then what type of strategy performs best? That depends on whether the term structure is backwardated or in contango.  When backwardation is prevalent, the front month contracts have outperformed, and when contango is predominant, the forward months have performed better.  From 2004-2011, contango dominated but in 2013 that changed.  However, it takes time to move from one persistent term structure to the next given inventories can be slow moving in either direction. It can take some time for inventories to be drawn down and also may be difficult to replenish. This is similar in energy as it is in other commodities that are difficult to store, like agriculture.

Below is a chart and table demonstrating the long term gain by using a dynamic roll strategy in energy.  The sector is comprised roughly of 35% each WTI and Brent, 10% gasoil, 7.5% each of heating oil and unleaded gasoline, and 5% natural gas. Overall the annualized return since inception in 1999 is 12.7% for the S&P GSCI Energy Dynamic Roll and 3.5% for the S&P GSCI Energy.

energy dynamic roll

Certain commodities are more sensitive to the term structure that you can see below in the table. For example, heating oil and unleaded gasoline have front contracts that have outperformed later dated, more flexible strategies.  As oil gets cheaper, the price for refined oil like heating oil and unleaded gasoline may drop, causing demand to increase and inventories to fall.

energy dynamic roll

Source: S&P Dow Jones Indices. Past performance is not an indication of future results.

 

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

Dreams to Sell

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Craig Lazzara

Managing Director and Global Head of Index Investment Strategy

S&P Dow Jones Indices

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If there were dreams to sell, a poet asked, what would you buy?  Much more prosaically, if you could design your dream investment process, what would it look like?

A simple way to think about the question is to separate success into two dimensions: frequency and magnitude.  Frequency means how often we “win” (i.e., how often our strategy outperforms its benchmark); magnitude measures the size of the winnings (i.e., the average value added when we win, and the average value lost when we lose).  In the best of all possible worlds, we’d win most of the time, and the average outperformance in our winning months would be much higher than the average underperformance in our losing months.

Since we don’t live in the best of all possible worlds, compromise is necessary.  Suppose we could only outperform half the time.  Our investment process would still be a net winner if its wins were bigger than its losses — in other words, if its average outperformance (during winning months) were bigger than its average underperformance (during losing months).

Dispersion gives us a way to gauge the likely differences between the returns of a particular strategy and those of a market benchmark.  This is true whether the strategy in question is active or is a factor or “smart beta” index.  When dispersion is high, the strategy is likely to deviate from its benchmark by a relatively large amount; when dispersion is low, deviations are likely to be smaller.  So: if our wins occur when dispersion is relatively high, and our losses when dispersion is relatively low — our investment process might still accumulate considerable value, even it wins only half the time.

There’s a strong historical tendency for high dispersion and negative returns to go hand-in-hand, as shown here for the S&P 500:

Dispersion by market regime

When the S&P 500’s returns are at their most negative, dispersion tends to be well above average.  When returns are positive, dispersion tends to be slightly below average.  This means, other things equal, that a strategy that tends to win when the market is down and to lose when the market is up will have a natural performance advantage, since its hits will occur in times of high dispersion.

This is exactly the pattern of returns exhibited by low volatility indices, as well as by other defensive strategies such as the S&P 500 Dividend Aristocrats.  We expect such strategies to do relatively well when the market declines.  The remarkable thing about them is that they also tend to outperform over the long run, despite the market’s secular upward bias.  Arguably, this is because they tend to win when dispersion is relatively high, and to lose when dispersion is relatively low.  They are therefore more likely to outperform when the reward for outperformance is high.

Differential returns can often be a consequence of index dispersion.  The distribution of dispersion favors strategies that outperform in down markets.

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