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Two ugly views of the energy debt markets

International Corporate Bond Exposure

Puerto Rico Municipal Bonds: The Damage Done...so far.

The Neutral Rate of Interest

Rising Interest Rates May Not Have an Immediate Impact on Senior Loan Rates

Two ugly views of the energy debt markets

Contributor Image
J.R. Rieger

Former Head of Fixed Income Indices

S&P Dow Jones Indices

The impact of low energy prices is rippling through the debt markets for bonds issued by energy related companies.  The S&P 500 Bond Index has returned a modestly negative total return of -0.31% year-to-date while the energy bond sector tracked in the S&P 500 Energy Corporate Bond Index is down 5.79% year-to-date.

Table 1: Select Sector Indices from the S&P 500 Bond Index family:

500 bond sectors 12 2015

The credit default market also has reacted.  The cost of buying default protection on the debt of the 10 entities in the S&P/ISDA CDS U.S. Energy Select 10 Index has shot upward by over 150% since May 1st 2015 from 213bps to end December 3rd 2015 at 539bps.  This could be an indication that market participants are expecting more downward pressure for this sector over the near term.

Chart 1: Select S&P/ISDA U.S. CDS Indices

Energy CDS 12 2015

Table 2: The 10 entities in the S&P/ISDA U.S. Energy Select 10 Index as of December 3rd 2015:

 Anadarko Petroleum Corp.
Apache Corp
Chesapeake Energy Corp.
ConocoPhillips
Devon Energy Corporation
Halliburton Company
Kinder Morgan Energy Partners LP
Peabody Energy Corporation
Valero Energy Corp.
Williams Companies, Inc./The

 

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

International Corporate Bond Exposure

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Lucas Chiang

Associate, Product Management

S&P Dow Jones Indices

Consistency and balance are often essential qualities for a strong portfolio. In the fixed income space, investors can look to the S&P International Corporate Bond Index to bolster the stability and diversity of their investments through exposure to investment grade corporate debt outside the United States.

International corporate bonds are issued in a variety of non-U.S. dollar currencies, which helps mitigate U.S. dollar risk. In an environment where the U.S. dollar is weakening, having a basket of non-U.S. dollar securities tends to add to total return after currency translation. Beyond that, international bonds have demonstrated a relatively low correlation with the domestic and global equity marketplace, as well as with fixed income. Diversifying with international corporate bonds can potentially reduce exposure to market variations of a single currency, issuer, and asset class.

When comparing the S&P International Corporate Bond Index to indices of different asset classes and even similar indices within the same asset class we can find additional reasons to take interest in international bonds. Historically, the S&P International Corporate Bond Index has demonstrated relatively lower volatility than equity and commodity indices such as the   S&P 500® and the S&P GSCI®.  In addition, as of November 30th, the average rating quality of the S&P International Bond Index outranks that of the S&P U.S. Issued Investment Grade Corporate Bond Index with average weighted ratings of A/A- and A-/BBB+, respectively.  While high quality ratings often imply lower yields, the S&P International Corporate Bond Index has a weighted average yield-to-worst of 2.16%, which is higher than the average yields of U.S. treasuries and comparable to the 2.26% yield of the S&P 500 AAA Investment Corporate Bond Index. In all, international corporate bonds can be a dependable and important part of an investor’s portfolio.

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

Puerto Rico Municipal Bonds: The Damage Done...so far.

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J.R. Rieger

Former Head of Fixed Income Indices

S&P Dow Jones Indices

While the Puerto Rico municipal bond market saga continues the damage it has done has been significant.    Puerto Rico municipal bonds represent approximately 23% of the market value of the S&P Municipal Bond High Yield Index.  The impact on total returns of this segment of the market have been dramatic.  The table below illustrates the performance with and without Puerto Rico.  High yield municipal bonds have actually had an excellent year in total return of over 6%, that is when you exclude Puerto Rico exposure.  Happy to send the time series of data on both indices to those interested in diving deeper.

Table 1: Select Municipal Bond Index ReturnsMunicipal Returns Nov 2015

The chart below shows performance over time of the two indices both reset to 100 as of November 2011.

Chart 1: Select Municipal Bond Indices Total Return Index Levels

Municipal Bond Index Levels November 2015

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

The Neutral Rate of Interest

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David Blitzer

Former Managing Director and Chairman of the Index Committee

S&P Dow Jones Indices

Several Fed policy-makers are focusing their comments and analyses on the neutral rate of interest – a level of the real (inflation-adjusted) Fed funds rate that will neither slow down nor speed up the economy.  If the Fed funds were set at this level, inflation and unemployment would be stable.  The neutral rate changes depending on economic conditions and is ultimately unknown. Despite the measurement problems, it is useful in setting and evaluating monetary policy.

While the neutral rate idea has appeared recently, it is close to an older concept of a natural interest rate due to the Swedish economist, Knut Wicksell (1851-1926). Today’s approach focuses on how the neutral rate changes as the economy adjusts.

The neutral rate is a benchmark for judging the stance of monetary policy.  When the real Fed funds rate is lower than the neutral rate, monetary policy is accommodative and will lead to lower unemployment, faster growth and increased inflation; if the real Fed funds rate is above the neutral rate, the reverse trends will be in place. While we don’t know exactly what the neutral rate is today, we do know how it changes as the economic and financial conditions evolve.  Combined with an understanding of how accommodative or restrictive monetary policy presently, we can judge how policy should adjust.  These ideas, along with current data, are behind the arguments for an increase in the Fed funds Rate, possibly as soon as December 16th, a couple of weeks away.

In a recession with employment and inflation falling, pessimistic expectations of the future and few short term investment opportunities, the economy has very little momentum. Even relatively modest interest rate levels may dampen economic activity. In this situation the neutral rate will be quite low. During the last recession in 2007-2009, the neutral rate was zero or less; in Europe today the recent action of the European Central Bank suggests it is close to zero. As economic growth resumes in a recovery and as pessimism shifts to neutral and then to optimism, the neutral rate will rise. If the recovery progresses, increased demand for credit and rising investment will push the neutral rate higher.  In a recession, the central bank will seek to keep the Fed funds rate below the neutral rate to support the economy.  As the economy improves and the neutral rate rises, the central bank either lifts the Fed funds target to follow the neutral rate up or risks a much too simulative policy position and inflation.  How far the real Fed funds rate is above or below the neutral rate affects how aggressive the policy is.

When the real Fed funds rate is close to the neutral rate, monetary policy will gradually move the economy; when spread widens the impact of monetary policy increases.   The large rate moves in the early days of the financial crisis and the extremely high interest rates in the 1979-82 inflation wars are examples. Today, there is no room to lower the Fed funds rate; even if the Fed raises its target later this month there will be a little room.  But there is plenty of upside – if inflation were suddenly a worry the central bank could easily boost the Fed funds target well above the neutral rate.  The importance of this is the asymmetry of risks: keeping interest rates a bit too low buys insurance against unexpected slowness in the economy.  Rushing to raise interest rates in fear of inflation makes little sense since there is plenty of upside if tighter policies are suddenly needed.

That no one knows precisely where the neutral rate is hasn’t stopped people from estimating its position. The chart from a recent speech by Fed Chair Janet Yellen shows four estimates of the neutral rate.

Yellen

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

Rising Interest Rates May Not Have an Immediate Impact on Senior Loan Rates

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Lucas Chiang

Associate, Product Management

S&P Dow Jones Indices

Following months of uncertainty, the U.S. Federal Reserve has indicated that there could soon be a hike in the Federal Funds Target Rate.  Interest rates have been kept in a range between zero and one-quarter of a percent since December 2008 and have not risen since June 2006.

As interest rates have been at historically low levels for nearly the last seven years, some fixed income investors have shifted their focus to senior loan securities with floating-rate characteristics, such as interest rate floors, to protect themselves in the event of falling rates.  Interest rate floors protect the loan interest rate by increasing the loan interest rate to the spread plus the floor if the reference rate ever falls below the floor.  Simply put, the formula for loan rates in these structures can be stated as follows.

Loan Interest Rate = Maximum of (Reference Rate or Floor) + Spread

As of Nov. 28, 2015, the S&P/LSTA U.S. Leveraged Loan 100 Index consisted of 100 senior loans, of which 91 had interest rate floors based on the Federal Funds Target Rate.  Of those loans, 31 had a floor of 0.75%, 55 had a floor of 1.00%, and 5 had a floor of 1.25%.  As the Federal Funds Target Rate is currently below these floors, we know that the loan interest rates are currently established by the interest rate floors instead.  This implies that as interest rates begin to rise, we may not see an immediate impact on senior loans with interest rate floors.  Lenders may have to wait until the Federal Funds Target Rate rises above 0.75% for the rising interest rates to make a significant impact on this basket of loans.

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